Digital Pricing and Hedging

Christian Kamtchueng ∗
CTK corp
London,UK

ESSEC
Paris,FRANCE

christian.kamtchueng@gmail.com

First version: Oct 15, 2010

This version: 10 Fev, 2011

Abstract
Autocallable option is an exotic option which is not a real challenge in term of pricing
and payoff. The difficulty comes from the greek instabilities and the hedge associated with
the option. This sentence could be strange for a fresh graduate because in theory the option
price is linked to his hedge. The first thing I learnt from the buissness is that the theory is
the theory! So considering the hedge what should be the best way of thinking. Is the price
process smooth enough to have stable greeks? What happens close to the maturity? The
quants have their answers but the traders have their problems too.
This article is the first part of the answer. It is focus on the digital pricing and hedging.

∗ The opinions of this article are those of the author and do not reflect in any way the views or business

of his employer.

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Contents
1 Introduction 3

2 Graduate Pricing Theory 4

2.1 BS and Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 BS dynamic hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.1 Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.2 Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.2.3 Vega . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.3 BS Intuition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3 Trader Hedging Strategy 12

3.1 Payoff Replication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3.2 Over Replication via Call Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

4 Risk Manager Evaluation 15

5 Applications 16
5.1 Pricing Impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
5.2 Hedging: P and L impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

6 Conclusion 19

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1 Introduction
We will be focus on the digital option. It is not a vanilla product even if it could be very liquid
for some asset classes (FX). The payoff which looks like vanilla is a real challenge in term of
risk management and hedging. The option pricing theory links a price to a hedge. In fact, this
association is not so clear in practice. Indeed there is a difference between theoretical price
and practical hedge. Through this note we wil try to highlight this difference, by changing
our business point of view. Indeed a graduate, a trader and a risk manager don’t see this
option with the same eyes.
The task of this article is to first enumerate the challenge behind the digital payoff, then help
to elaborate some ways to deal with its discontuinity.

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MC() l1
mc = 0 l2
for j = 1 , j ≤ nbPaths: l3
S[0][j] = s0 l4
for i = 1 , j ≤ nbFixings: l5
S[i][j]= Simul(S[i-1][j],δi ) l6
P = (S[i][NbFixing] > Strike) ? 1 : 0 l7
mc = mc + P l8
return mc/NbPaths l9
l10

Figure 1: Digital Simple Algo

2 Graduate Pricing Theory

First let us review the payoff of a digital option: typically it is an option which gives to the
buyer (long) one if the underlying is above a certain strike K at maturity T , 0 otherwise.
h RT i
Digital (T, K) = EQ e− 0 rs ds 1{ST >K}
RT
= e− 0
rs ds
Q (ST > K)

Before any consideration, given a dynamic for the underlying, a Monte-Carlo method knowl-
edge seems enough to price this option (see the simple algorithm Figure 1).

2.1 BS and Price

In [1], Black and Scholes describes a world where every payoff is replicable via a dynamic and
continious delta hedging. If we are under Black and Scholes hyppothesis for our underlying
what should the price of our option be?

h i
dSt = St rt dt + σS dWtQ
S0 = s

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h RT i
Digital (T, K) = EQ e− 0 rs ds 1{ST >K}
RT
= e− 0
rs ds
Q (ST > K)
RT !
RT ln Ks − rs ds + 12 σS2 T
= e− 0
rs ds
Q WTQ > 0
σS
RT !
RT ln K − 0 rs ds + 21 σS2 T
=
|{z} e− 0
rs ds
Q X> s
√
σS T
X∼
=N (0,1)
 
RT
RT  ln s + 0 rs ds − 21 σS2 T 
e− rs ds
Q X < K
 
= 0 √ 
 σS T 
| {z }
d1
RT
− rs ds
= e 0 N (d1 )

1.0

-2D
-10H
0.5 -5H
-1H
-30m
Price

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 2: Digital Price strike 100 vol 7% (remaining maturity) as a function of spot level

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1.0

-2D
-10H
0.5 -5H
-1H
-30m
Price

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 3: Digital Price strike 100 vol 15% (remaining maturity) as a function of spot level

Notations for the remaining maturities of the Figures 2-9 and 16-21 are the following:

• 2D : 2 days
• 10h : 10 hours
• 5h : 5 hours
• 1h : 1 hour
• 30m : 30 minutes

2.2 BS dynamic hedging

In order to hedge dynamically our option under the Black and Scholes assumptions, we should
consider the Digital greeks.
Indeed the hedging portfolio is composed by delta position on the stock and the rest in cash.

2.2.1 Delta

h RT i
∂Digital (T, K) ∂ e− 0 rs ds N (d1 )
=
∂s ∂s
−
RT (d1 )
rs ds ∂N
= e 0
∂s
RT ∂d1
= e− 0 rs ds f (d1 )
∂s
R
− 0T rs ds 1
= e f (d1 ) √
σS T s

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 7

N (x) = Q (X > K)
X ∼= N (0, 1)
x2
e− 2
f (x) = √
2π

6
Delta

-2D
-10H
-5H
-1H
-30m
0.
99 99.5 spot level 100.0 100.5 101.0
Figure 4: Digital Delta strike 100 vol 7% (remaining maturity) as a function of spot level

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4.0

3.5

3.0

2.5

2.0

1.5
Delta

-2D
1.0 -10H
-5H
-1H
0.5
-30m

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 5: Digital Delta strike 100 vol 15% (remaining maturity) as a function of spot level

2.2.2 Gamma

∂ 2 Digital (T, K) ∂ ∂Digital (T, K)

=
∂s2 ∂sh ∂s i
R
− 0T rs ds 1
∂ e f (d1 ) σ √
Ts
S
=
h∂s i
1
RT ∂ f (d1 ) σ √
Ts
= e− 0
rs ds S

∂s h i

  ∂ 1
√
RT d1 1 σS T s
= e− 0 rs ds f (d1 )  √ √ + 
σ 2πT σS T s ∂s
 
RT d1 1 1
= e− 0 rs ds f (d1 ) √ √ − √
σ 2πT σS T s σS T s2

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1500

1000

500 -2D
-10H
-5H
-1H
-30m
Gamma

0. spot level
99.5 100.0 100.5 101.0

−500

−1000

−1500

Figure 6: Digital Gamma strike 100 vol 7% (remaining maturity) in function of spot level

500 -2D
-10H
-5H
-1H
-30m
Gamma

0. spot level
99.5 100.0 100.5 101.0

−500

Figure 7: Digital Gamma strike 100 vol 15% (remaining maturity) as a function of spot level

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2.2.3 Vega

h RT i
∂Digital (T, K) ∂ e− 0 rs ds N (d1 )
=
∂σS ∂σS
RT ∂N (d1 )
= e− 0 rs ds
∂σS
R
− 0T rs ds ∂d1
= e f (d1 )
∂σS
 
R
− 0T rs ds d1 √
= e f (d1 ) − − σS T
σS

3.5

3.0

2.5

2.0 -2D
1.5 -10H
-5H
1.0
-1H
0.5
-30m
Price

0.
99.5 spot level 100.0 100.5 101.0
−0.5

−1.0

−1.5

−2.0

−2.5

−3.0

−3.5

Figure 8: Digital Vega strike 100 vol 7% (remaining maturity) as a function of spot level

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1.5
-2D
1.0 -10H
-5H
0.5 -1H
-30m
Vega

0.
99.5 spot level 100.0 100.5 101.0
−0.5

−1.0

−1.5

Figure 9: Digital Vega strike 100 vol 15% (remaining maturity) as a function of spot level

2.3 BS Intuition
We have some issues with this approach:

• The continuous dynamic hedging is very critical when in practice you hedge your posi-
tion discretly. How will the trader deal with the greek’s instability and unsmoothness
(close to maturity and close to the strike, Figures 4-9)?
• Second point, which volatility should we use? It is well known that the Black And
Scholes model does not reflect the reality in term of asset dynamic (even if it is the
way vanillas are quoted – by vanillas, the market means calls and puts –) How can we
retrieve a digital price from the quoted calls and puts?

In order to illustrate the two points above, we will analyse some case scenarios.
First we can deduce from the Figures 4-7 the greek instability zone which depends on the
remaining maturity and the asset volatility. In fact we can see easily two zones: delta positive
and delta null (or gamma no null and gamma null). We will call the delta positive zone the
”‘red”’ zone, critical close to the maturity and for a spot level close to the strike.
As a trader, we will rebalance our portfolio discretly on the daily basis. After our last rebal-
ancing period, the stock can still move from a delta null zone to a delta positive (eg it can
enter in the ”‘red”’zone).
The maturity approching, we have two choices:

• We can increase the frequency of our hedging, and observe in function of the stock
movement some delta jumps more or less important.
• We can keep our position, therefore our hedging portfolio will be affected positively or
negatively by the missing rebalancing (in our case negatively) called residual hedging.

As we can see in the Figure 4-7, in the ”‘red”’ zone a small move of the underlying can lead
to a big delta move (hudge gamma). Therefore, the missing hedge resulting from the discret
hedging can have hudge consequences.
Even if intuitively when ∆, the rebalancing frequency, tends to zero our hedge become con-
tinious, as small as ∆ is, a move of the stock during the last ∆ period can be fatal for our
replication strategy.

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The gamma play another role, in sense that

it impacts significatively the tracking error et of
the delta hedging, det ≈ O Γt σS2 − σBS
2
dt . Given the market volatility of the call and the
put, how can we deduce the digital price? Is there another way to replicate it?
A call option is an option where we give the right to buy a stock S at a certain date T , called
maturity, at price K called strike.
h RT i
+
Call (T, K) = EQ e− 0 rs ds (ST − K)
h RT i RT
= EQ e− 0 rs ds ST 1{ST >K} − Ke− 0 rs ds Q (ST > K)
 R 
T ST RT
= sEQ e− 0 rs ds 1{ST >K} − Ke− 0 rs ds Q (ST > K)
s
RT
dQS S
0 rs ds T
dQ :=e− s
z}|{ RT
= s QS (ST > K) −K e− 0
rs ds
Q (ST > K)
| {z } | {z }
DigitalS (T,K) Digital(T,K)

One can note that one part of the last equation is model dependent. We can do better than
the last equation by linking the digital with the sensitivity of a call option:
∂Call (T, K)
Digital (T, K) = −
∂K
Call (T, K) − Call (T, K + ǫ) ǫ→0
→ Digital (T, K)
ǫ

So how can deal the trader with these equations mathematically correct without taking into
account the discret hedging and the discrete market?

3 Trader Hedging Strategy

As we have desmontrated in the last section the risk neutral price of the digital could easily
be computed by Monte Carlo given a distribution for S, however if you want to use dynamic
hedging we realize that the greeks are very unstable and can diverge when we are close to
the maturity. Why not consider a static hedging strategy instead?

3.1 Payoff Replication

The problem of our payoff is the regular point At The Money. We are looking for a combinaison
of vanillas able to replicate or over replicate the digital. Our previous studies converge to the
call spread option (difference between two calls).

CallSpread(K − ǫ, K) ǫ→0
→ Digital(K)
ǫ

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Payoffs

1.5

1.0

0.5

Digital Strike=50.
0.
0. 10 20 30 40 50 60 70 80 90 100

Figure 10: Digital Payoff

As we can see above, we can build a portfolio able to deliver at maturity the payoff of the
digital. The formula considering the limit of a call spread is not efficient as we have to
consider a fixed ǫ. If we are sellers, we will overprice the option via a propriate call spread
option (compare Figure 2-3 with Figure 16-17).

N
CallSpread(K − ǫ, K) ∼
= N Digital(K)
ǫ

How can a trader, who has to hedge the digital risk, choose the ǫ value?

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Payoffs

1.5

1.0

0.5

CallSpread Strikes=45-55
CallSpread Strikes=50-60
CallSpread Strikes=40-50
Digital Strike=50.
0.
0. 10 20 30 40 50 60 70 80 90 100

Figure 11: Classic Digital Risk Smoothing

3.2 Over Replication via Call Spread

If we want to use a static overhedge we have to consider the market call.

• If the Call (T, K) and Call (T, K − ǫ) are available in the market, why would the investor
need you? Your price will be inefficient! we have an upper boundary for ǫ.
• If you have access to brokers quotes, you could have a more interesting price.
• Alternatively you could consider dynamic hedging of your call spread position. Given
the hedging of the call, you can build a portfolio composed of a position on stock S and
cash able to replicate the call spread. In addition to a more reasonable level, the greek of
the call spread position are more stable than the digital ones ( compare Figures 4-7 with
Figures 18-21). Therefore the impact of the greek instabilities (described previously)
will be reduced.
Altought it is true in theory for all the ǫ, our issue concerning the residual hedge result-
ing of our discret hedge could not be fixed. Indeed a too small ǫ implies the same delta
problem.
The stock can in one ∆ period move to one delta zone to another. Intuitively, we could
hedge a 0 payout in our last rebalancing period ∆ whereas the stock could move above
the strike. So ǫ has to be higher than the historical-∆ move of the stock. In fact, ǫ should
be such as the stock can not go to the delta null zone lower (higher) than the strike from
the one higher (lower) than the strike in one ∆ period.

As we have just noticed our choice of ǫ will depend of the frequency of our hedging (more
precisely the last period) and the historical delta movement of the underlying during our
rebalancing period. So ǫ is stock and strategy dependant. In Figure 12, we show the Profit
and Loss of the digital replication as a function of the rebalancing frequency. In Table 3 the
Profit and Loss as a function of the choice of ǫ.

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4 Risk Manager Evaluation

The risk manager as the trader would have to evaluate the delta gap risk of the digital.
However he does not care about the price efficiency. As we have seen the digital replication
via a call spread option depends on our position, short or long the option (see Figure 11). This
replication is not risk neutral, the risk manager wants to be conservative. His main focus
will be the subjective determination of ǫ.
The way you extract and estimate the historical distribution of the underlying, affects your
daily delta move:

• How will you chose your data?

• Will you consider the crisis period?

Following the recent criris (2001-2006), the regulators asked for more numbers. They wanted
them simple enough to be understandable but complex enough to have a meaning.
there is more than one approach to evaluate this risk :

• Estimated the historical delta move and stress it.

• Implied ǫ from a percentile of the stock ∆ return distribution.

• Implied ǫ from a percentile of the Profit and Loss distribution via Monte-Carlo.

• Implied ǫ from a potential exposure.

compute the probability to be in the ”‘red ”’ zone pB := Q (ST − ∈ B) then multiplied pB
by:
h i h i
– delta E ∂P∂s(ǫ) |s ∈ B , determine ǫ such as E ∂P∂s(ǫ) ≤ DeltaLimit. Bounded our
stock exposure during the most sensitive period.
h 2 i h 2 i
P (ǫ) ∂ P (ǫ)
– gamma E ∂ ∂s 2 |s ∈ B , determine ǫ such as E ∂s2 ≤ GammaLimit. Control
our model error and reduced the sensitivity of our residual hedging to a stock move-
ment.

In top of the hedging risk consequence of the greek instabilities, there is also a model risk
link to the missing data. How can we determine the market volatility at the missing strike(s)
K and K ± ǫ of our Call Spread?
Indeed the missing strike(s) will be subject to the interpolation method. The risk manager
could use an uncertain volatility model to compute a reasonable valuation of the digital risk
via a call spread (see [5],[6]), unfortunately this replication could be too expensive and re-
jected by the trading although it represents a real solution to the illiquid strike(s).

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5 Applications

5.1 Pricing Impact

The price of the digital is more link to the interpolation method than the stochastic modeling
error. Indeed, the replication as we explained earlier is dynamic, the strike K − ǫ is not
available in the market, the valuation of this illiquid point is a consequence of our model
but also and above all of our interpolation method. We will consider 2 interpolation methods
(linear and Bezier) for a skew composed by 3 strikes (0.9 - 1 - 1.1) and 2 models which take
the skew into account local vol [4] and Heston [3].
Actually, the existence of a continuim of call and put is one of the hypothesis of the local
volatility model, therefore, the price of the digital is just link to our interpolation method.
Whereas in order to separate the interpolation to our pricing, we will for the Heston case
consider the market quotes then our digital price after calibration.

Heston Bezier Strikes Linear

spot based
θ1 θ2 ǫ = 1% ǫ = 10%

0.713 0.715 0.686 0.719 90% 0.691

0.510 0.511 0.608 0.719 100% 0.691

0.307 0.306 0.520 0.559 110% 0.516

Table 1: Digital Pricing

In the table above, θ1 and θ2 have the same calibration errors (in fact we just have changed
our parameters constraints in order to product another valid set of parameters from the same
market data).
To summurize we can identify different types of pricing factor which impact the digital prices:

• For the Heston it is a model extrapolation and interpolation. Given our discrete market,
the calibration procedure will determine the price of the digital.

• For the local volatility which is directly related to our interpolation and extrapolation
method (no calibration needed) we have two source of noices:

– finite difference approximation

– interpolation extrapolation between strikes

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Interpolation (K − ǫ, K) (K, K + ǫ) (K − ǫ, K + ǫ)
ǫ = 1% ǫ = 1% ǫ = 1%
Linear 0.691 0.515 0.603
Bezier 0.608 0.599 0.603

Table 2: Digital Price in function of Interpolation and Finite Difference Approximation

5.2 Hedging: P and L impact

analysis: there are tree sources of risk in the digital hedging:

• discrete hedging

• dynamic hedging

• greek instability

All our results are for a ATM spot digital option maturity 2Y, the P and L distribution is
computed by Monte Carlo with 2000 paths under the Black And Scholes assumptions.

P and L Digital Call Spread, ǫ:= Highest delta move Call Spread, ǫ:= Average delta move
20D 1W 2D 1D 20D 1W 2D 1D
Mean -0.316 -0.094 -0.088 -0.084 -0.104 -0.092 -0.092 -0.093 -0.104
Var 0.573 0.347 0.349 0.344 0.352 0.346 0.350 0.350 0.355

Table 3: P and L call spread strikes for a stock variance = 0.03

P and L Digital Call Spread

1D 2D 1W 20D 1D 2D 1W 20D
Mean -0.316 -0.135 -0.073 -0.023 -0.093 -0.057 -0.025 -0.019
Var 0.573 0.342 0.270 0.240 0.350 0.299 0.257 0.243

Table 4: P and L rebalancing frequency for a stock variance = 0.03

In our study, we do not consider the well known theorical result which consist to a perfect
dynamic and continuous replication of the digital via a delta hedging which can be evalutate
theoriticaly. However we will be focus upon on a discrete rebalancing of our portfolio and we
will demonstrate that lock our portfolio before the instability can have a benefit. In Theory
the discrete rebalancing will increase our loss but in the digital case, increase the hedging
frequency and carry our hedge during the greek explosion can be damagable to our P and
L distribution as it can be seen in Table 4 and 5. Note that if we lock it before the greek
instability the call spread and digital delta hedge should have a similar P and L distribution

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 18

P and L Digital Call Spread

2D (3D) 3D (1W) 5D (9D) 2D (3D) 3D (1W) 5D (9D)
Mean -0.100 -0.059 -0.047 -0.052 -0.037 -0.031
Var 0.327 0.281 0.274 0.280 0.257 0.253

Table 5: P and L freezing period (rebalancing frequency) for a stock variance = 0.03

P and L Digital Call Spread

1D 2D 1W 20D 1D 2D 1W 20D
Mean -0.184 -0.082 -0.057 -0.048 -0.068 -0.035 -0.037 -0.040
Var 0.349 0.272 0.252 0.242 0.311 0.263 0.253 0.247

Table 6: P and L rebalancing frequency for a stock variance = 0.5

(Table 5). We can see for instance in the Figure 12 that the 20D rebalancing Digital has a
distribution similar to the Call Spread.
The market risk manager will remind you that the purpose is not in the average gain but
in limitation of our potential loss. As it is shown in Table 1, the smoothing of the Payoff via
a Call Spread Option reduce the variance of our P and L distribution. The risk is real we
could lose a huge amount by hedging dynamically the digital itself, in the Figure 7 and 8 we
can see that the losses resulting of the digital delta hedge can be 4 times higher than a call
spread one. To avoid or reduce the huge potential losses a smoothing of the digital payoff is
necessary (see Figure 18-21).

0.55

0.50

0.45

0.40

0.35
-CallSpread20D
0.30
-CallSpread1W
-CallSpread2D
-CallSpread1D
0.25 -Digital20D
Frequency

-Digital1W
0.20
-Digital2D
-Digital1D
0.15

0.10

0.05

−2.0 −1.5 −1.0 −0.5 0. 0.5 1.0 1.5 2.0

P and L error
Figure 12: P and L distribution Rebalancing Frequency

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6 Conclusion
A digital option is far away to be a vanilla one. This option as it has been explained should
not be reduced to his banal payoff. The digital is not easy to hedge and risk managed. Each
part of the business participant will have his main focus.

• Interpolation and extrapolation of the market for the quant.

• Hedging frequency strategy for the trader.

• Underlying historical behaviour of the stock for the risk manager

• Numerical pricing method for the graduate

The smoothing of the digital risk is very dependant of the views of the business. This subjec-
tivity is a real problem if we would like to consider the digital as market building blocks (this
will be discussed in a future publication). Another study can be done on the American Digital
Risk of an Autocallable (see [7]).

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References
[1] F.Black and M.Scholes, Pricing of Options and Corporate Liabilities, (1973)
[2] R.C.Merton, Theory of Rational Option Pricing, (1976)

[3] S.L.Heston, A Closed-Form Solution for Options with Stochastic Volatility with Applica-
tion to Bond and Currency Options, (1993)

[4] B.Dupire, Pricing with a smile, (1994)

[5] M.Avellaneda, A.Levy, A.Paras Pricing and Hedging in Markets with Uncertain Volatil-
ity, (1995)

[6] C.Kamtchueng, Uncertain Monte Carlo, (2010)

[7] C.Kamtchueng, Autocallable More American Than European, (2011)

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1.0

-2D
-10H
0.5 -5H
-1H
-30m
Price

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 13: Call Spread Price strike 100-99 vol 7% (remaining maturity) in function of spot
level

1.0

-2D
-10H
0.5 -5H
-1H
-30m
Price

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 14: Call Spread Price strike 100-99 vol 15% (remaining maturity) in function of spot
level

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 22

1.0

-2D
-10H
-5H
0.5 -1H
-30m
Delta

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 15: Call Spread Delta strike 100 vol 7% (remaining maturity) in function of spot level

1.0

-2D
-10H
-5H
0.5 -1H
-30m
Delta

0.
99 99.5 spot level 100.0 100.5 101.0
Figure 16: Call Spread Delta strike 100-99 vol 15% (remaining maturity) in function of spot
level

Electronic copy available at: https://ssrn.com/abstract=1924525

 23

100

50 -2D
-10H
-5H
-1H
-30m
Gamma

spot level
0.
99.5 100.0 100.5 101.0

−50

−100

Figure 17: Call Spread Gamma strike 100 vol 7% (remaining maturity) in function of spot
level

25

20

15
Gamma

10 -2D
-10H
5 -5H
-1H
spot level -30m
0.
99.5 100.0 100.5 101.0
−5

−10

−15

−20

−25

Figure 18: Call Spread Gamma strike 100-99 vol 15% (remaining maturity) in function of
spot level

Electronic copy available at: https://ssrn.com/abstract=1924525

 24

Figure 19: Digital Delta Hedge P and L

Figure 20: Digital-Call Spread Delta Hedge P and L

Electronic copy available at: https://ssrn.com/abstract=1924525