FINANCIAL MODELING

LECTURE NOTES

Professor Moisă ALTĂR ,

R A U, Bucharest, 2022

1
 References

1.John C. Hull (2012): Options, Futures, and other

derivatives, Prentice Hall, New York
2.Moisa Altar (2002 ): Financial Engineering, part.I,
Dofin, Buharest,www.dofin.ase.ro (in Romanian)
3. Moisa Altar (2003 ): Financial Engineering, part.II,
Dofin, Buharest,www.dofin.ase.ro (in Romanian)
4.Moisa Altar (2002,2003):Solutions for the Financial
Engineering Exam.,Dofin, Buharest,www.dofin.ase.ro
(in Romanian)
2
 What is a Derivative?

 A derivative is an instrument whose value

depends on, or is derived from, the value of
another asset.
 Examples: futures, forwards, swaps, options,
exotics…

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 Why Derivatives Are Important

 Derivatives play a key role in transferring risks in the

economy
 The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc
 Many financial transactions have embedded
derivatives
 The real options approach to assessing capital
investment decisions has become widely accepted

4
 How Derivatives Are Traded

 On exchanges such as the Chicago Board

Options Exchange
 In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly

5
 How Derivatives are Used

 To hedge risks
 To speculate (take a view on the future
direction of the market)
 To lock in an arbitrage profit
 To change the nature of a liability
 To change the nature of an investment
without incurring the costs of selling one
portfolio and buying another
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 Forward Price

 The forward price for a contract is the

delivery price that would be applicable to the
contract if were negotiated today (i.e., it is the
delivery price that would make the contract
worth exactly zero)
 The forward price may be different for
contracts of different maturities (as shown by
the table)

7
 Terminology

 The party that has agreed to buy has what is

termed a long position
 The party that has agreed to sell has what is
termed a short position

8
 Profit from a Long Forward
Position (K= delivery price=forward price at
time contract is entered into

9
 Profit from a Short Forward
Position (K= delivery price=forward price at time
contract is entered into

10
 Futures Contracts
 Agreement to buy or sell an asset for a
certain price at a certain time
 Similar to forward contract
 Whereas a forward contract is traded OTC, a
futures contract is traded on an exchange

11
 Exchanges Trading Futures

 CME Group (formerly Chicago Mercantile

Exchange and Chicago Board of Trade)
 NYSE Euronext
 BM&F (Sao Paulo, Brazil)
 TIFFE (Tokyo)
 and many more (see list at end of book)

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 Examples of Futures Contracts

Agreement to:
– Buy 100 oz. of gold @ US$1400/oz. in December
– Sell £62,500 @ 1.4500 US$/£ in March
– Sell 1,000 bbl. of oil @ US$90/bbl. in April

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 1.Gold: An Arbitrage
Opportunity?

Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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 2.Gold: Another Arbitrage
Opportunity?

Suppose that:
- The spot price of gold is US$1,400
- The 1-year forward price of gold is US$1,400
- The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?

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 The Forward Price of Gold
(ignores the gold lease rate)

If the spot price of gold is S and the forward

price for a contract deliverable in T years is
F, then
F = S (1+r )T
where r is the 1-year (domestic currency)
risk-free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05
so that
F = 1400(1+0.05) = 1470
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 1. Oil: An Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is US$125
- The 1-year US$ interest rate is 5% per annum
- The storage costs of oil are 2% per annum
Is there an arbitrage opportunity?

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 2. Oil: Another Arbitrage
Opportunity?

Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is US$80
- The 1-year US$ interest rate is 5% per annum
- The storage costs of oil are 2% per annum
Is there an arbitrage opportunity?

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 Options

 A call option is an option to buy a certain

asset by a certain date for a certain price (the
strike price)
 A put option is an option to sell a certain
asset by a certain date for a certain price (the
strike price)

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 American vs European Options

 An American option can be exercised at any

time during its life
 A European option can be exercised only at
maturity

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 Options vs Futures/Forwards

 A futures/forward contract gives the holder

the obligation to buy or sell at a certain price
 An option gives the holder the right to buy or
sell at a certain price

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 Types of Traders

 Hedgers
 Speculators
 Arbitrageurs

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 Review of Option Types

 A call is an option to buy

 A put is an option to sell
 A European option can be exercised only at
the end of its life
 An American option can be exercised at any
time

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 Option Positions

 Long call
 Long put
 Short call
 Short put

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 Long Call (Figure 9.1, Page 195)

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 Short Call (Figure 9.3, page 197)

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 Long Put (Figure 9.2, page 196)

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 Short Put (Figure 9.4, page 197)

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 Payoffs from Options

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 Assets Underlying
Exchange-Traded Options

Page 198-199
 Stocks
 Foreign Currency
 Stock Indices
 Futures

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 Specification of
Exchange-Traded Options

 Expiration date
 Strike price
 European or American
 Call or Put (option class)

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 Terminology

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 Convertible Bonds

 Convertible bonds are regular bonds that can

be exchanged for equity at certain times in
the future according to a predetermined
exchange ratio
 Usually a convertible is callable
 The call provision is a way in which the
issuer can force conversion at a time earlier
than the holder might otherwise choose

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 Notation

34
 Effect of Variables on Option
Pricing (Table 10.1, page 215)

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 American vs European Options

An American option is worth at least as much

as the corresponding European option
Cc
Pp

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 Lower Bound for Calls on
Non-Dividend-Paying Stocks

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 

39
 

40
 (Equation 10.4, page 220)

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 Now we can answer the arbitrage opportunity.
A lower bound for the price of a European call option on a
non-dividend-paying stock is

In this case,
Consider the situation where the European call price is
$3.00, which is less than the theoretical minimum of
$3.71. An arbitrageur can short the stock and buy the call
to provide a cash inflow of 20.00-3.00=$17.00. If
42 invested for 1 year at 10% per annum, the $17.00 grows to
 

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44
 Lower Bound for European Puts on
Non-Dividend-Paying Stocks

45
 

46
 Hence,

Because the worst that can happen to a put option is

that it expires worthless, its value cannot be
negative. This means that

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 Now we can answer the arbitrage opportunity.
In this case,
Consider the situation where the European put price
is $1.00, which is less than the theoretical minimum
of $2.01. An arbitrageur can borrow $38.00 for 6
months to buy both the put and the stock. At the end
of the 6 months, the arbitrageur will be required to
repay
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 If the stock price is below $40.00, the arbitrageur
exercisesthe option to sell the stock for $40.00, repays the
loan, and makes a profit of
$40.00- $38.96 =$1.04
If the stock price is greater than $40.00, the arbitrageur
discards the option, sells the stock, and repays the loan for
an even greater profit. For example, if the stock price is
$42, the arbitrageur’s profit is 42-38.96=$3.04

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 This relationship is known as put–call parity. It
shows that the value of a European call with a
certain exercise price and exercise date can be
deduced from the value of a European put with the
same exercise price and exercise date, and vice
versa.

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 In this case,

Portfolio C is overpriced relative to portfolio A. An

arbitrageur can buy the securities in portfolio A and short the
securities in portfolio C. The strategy involves buying the
call and shorting both the put and the stock, generating a
positive cash flow of -3+2.25+31=$30.25 up front.

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 When invested at the risk-free interest rate, this amount
grows to
in three months. If the stock price at expiration of the
option is greater than $30, the call will be exercised. If it is
less than $30, the put will be exercised. In either case, the
arbitrageur ends up buying one share for $30. This share
can be used to close out the short position. The net profit
is therefore 31.02-30.00=$1.02

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 For an alternative situation, suppose that the call price is
$3 and the put price is $1. In this case,

Portfolio A is overpriced relative to portfolio C. An

arbitrageur can short the securities in portfolio A and buy
the securities in portfolio C to lock in a profit. The
strategy involves shorting the call and buying both the put
and the stock with an initial investment of 31+1-3=$29
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 

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 Trading Strategies Involving Options

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 Put-call parity We represent a first step to understanding the
strategies based on option.
The put–call parity relationship is

where p is the price of a European put, S0 is the stock price,

c is the price of a European call, K is the strike price of both
call and put, r is the risk-free interest rate, T is the time to
maturity of both call and put, and D is the present value of
the dividends anticipated during the life of the options.

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 Equation (11.1) shows that a long position in a European put
combined with a long position in the stock is equivalent to a
long European call position plus a certain amount of cash

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 Equation (11.1) can be rearranged to become

This shows that a long position in a stock combined with a

short position in a European call is equivalent to a short
European put position plus a certain amount of cash
This equality explains why the profit pattern in Figure 11.1a
is similar to the profit pattern from a short put position. The
position in Figure 11.1b is the reverse of that in Figure 11.1a
and therefore leads to a profit pattern similar to that from a
long put position.
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 SPREADS

A spread trading strategy involves taking a position

in two or more options of the same type (i.e., two or
more calls or two or more puts).

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 1.Bull Spreads

One of the most popular types of spreads is a bull spread.

This can be created by buying a European call option on a
stock with a certain strike price and selling a European call
option on the same stock with a higher strike price. Both
options have the same expiration date.
A bull spread strategy limits the investor’s upside as well as
downside risk.

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 

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 2.Bear Spreads

An investor who enters into a bull spread is hoping that the

stock price will increase. By contrast, an investor who enters
into a bear spread is hoping that the stock price will decline.
Bear spreads can be created by buying a European put with
one strike price and selling a European put with another
strike price. The strike price of the option purchased is
greater than the strike price of the option sold. (This is in
contrast to a bull spread, where the strike price of the option
purchased is always less than the strike price of the option
sold.)

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 3. Box Spreads

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 buying a call with strike price K2, buying a put with strike
price K1, selling a call with strike price K1, and selling a put
with strike price K2

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 Butterfly Spreads

A butterfly spread involves positions in options with three

different strike prices. It can be created by buying a
European call option with a relatively low strike price K1,
buying a European call option with a relatively high strike
price K3, and selling two European call options with a strike
price K2 that is halfway between K1 and K3.
Generally, K2 is close to the current stock price. The pattern
of profits from the strategy is shown in Figure 11.6. A
butterfly spread leads to a profit if the stock price stays close
to K2, but gives rise to a small loss if there is a significant
81 stock price move in either direction. It is therefore an
 appropriate strategy for an investor who feels that
large stock price moves are unlikely. The strategy
requires a small investment initially. The payoff
from a butterfly spread is shown in Table 11.4

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 Calendar Spreads

A calendar spread can be created by selling a European call

option with a certain strike price and buying a longer-
maturity Eurpean call option with the same strike price.
The longer the maturity of an option, the more expensive it
usually is. A calendar spread therefore usually requires an
initial investment. Profit diagrams for calendar spreads are
usually produced so that they show the profit when the short-
maturity option expires on the assumption that the long-
maturity option is closed out at that time

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 A combination is an option trading strategy that involves
taking a position in both calls and puts on the same stock.
We will consider straddles, strips, straps, and strangles
Straddle
One popular combination is a straddle, which involves
buying a European call and put with the same strike price
and expiration date. The profit pattern is shown in Figure
11.10. The strike price is denoted by K. If the stock price is
close to this strike price at expiration

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 Strips and Straps

A strip consists of a long position in one European call and

two European puts with the same strike price and expiration
date. A strap consists of a long position in twoEuropean calls
and one European put with the same strike price and
expiration date.
The profit patterns from strips and straps are shown in Figure
11.11. In a strip the investor is betting that there will be a big
stock price move and considers a decrease in the stock price
to be more likely than an increase. In a strap the investor is
also betting that there will be a big stock price move.
However, in this case, an increase in the stockprice is
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considered to be more likely than a decrease.
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Key concepts

_ Basic properties of options

_ Binomial Option Pricing Model
_ Black-Scholes option pricing formula
3

125 23

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0
Let C be the current value of the call, Cu be its value at the end of the
period if the stock price goes to uS and Cd be its value at the end of the period if the
stock price goes to dS.
Suppose we form a portfolio containing Δ shares of stock and the dollar amount B in
riskless bonds. This will cost ΔS + B. At the end of the period, the value of this
portfolio will be
Since we can select Δ and B in any way we wish, suppose we choose them to equate the
end-of-period values of the portfolio and the call for each possible outcome. This
requires that

Solving these equations, we find

With Δ and B chosen in this way, we will call this the hedging portfolio.
If there are to be no riskless arbitrage opportunities, the current value of the call, C,
cannot be less than the current value of the hedging portfolio, ΔS + B. If it were, we
could make a riskless profit with no net investment by buying the call and selling
the portfolio. It is tempting to say that it also cannot be worth more, since then we
would have a riskless arbitrage opportunity by reversing our procedure and selling
the call and buying the portfolio. But this overlooks the fact that the person who
bought the call we sold has the right to exercise it immediately.
Suppose that ΔS + B < S – K. If we try to make an arbitrage profit by selling calls
for more than ΔS + B, but less than S – K, then we will soon find that we are the
source of arbitrage profits rather than the recipient. Anyone could make an arbitrage
profit by buying our calls andexercising them immediately.
We might hope that we will be spared this embarrassment because everyone will
somehow find it advantageous to hold the calls for one more period as an
investment rather than take a quick profit by exercising them immediately. But each
person will reason in the following way. If I do not exercise now, I will receive the
same payoff as a portfolio with ΔS in stock and B in bonds.
If I do exercise now, I can take the proceeds, S – K, buy this same portfolio and
some extra bonds as well, and have a higher payoff in every possible circumstance.
Consequently, no one would be willing to hold the calls for one more period.
Summing up all of this, we conclude that if there are to be no riskless arbitrage
opportunities, it must be true that

if this value is greater than S – K, and if not, C = S – K.

Equation (2) can be simplified by defining
so that we can write

It is easy to see that in the present case, with no dividends, this will always be greater
than S – K as long as the interest rate is positive. To avoid spending time on the
unimportant situations where the interest rate is less than or equal to zero, we will now
assume that r is always greater than one. Hence, (3) is the exact formula for the value
of a call one period prior to the expiration in terms of S, K, u, d, and r.
To confirm this, note that if uS ≤ K, then S < K and C = 0, so C > S – K. Also, if dS ≥ K,
then C = S – (K/r) > S – K. The remaining possibility is uS > K > dS. In this case, C =
p(uS – K)/r. This is greater than S – K if (1 – p)dS > (p – r)K, which is certainly true as
long as r > 1.
This formula has a number of notable features. First, the probability q does not appear
in the formula. This means, surprisingly, that even if different investors have different
subjective probabilities about an upward or downward movement in the stock, they
could still agree on the relationship of C to S, u, d, and r.
Second, the value of the call does not depend on investors’ attitudes toward risk. In
constructing the formula, the only assumption we made about an individual’s behavior
was that he prefers more wealth to less wealth and therefore has an incentive to take
advantage of profitable riskless arbitrage opportunities. We would obtain the same
formula whether investors are risk-averse or risk-preferring.
Third, the only random variable on which the call value depends is the stock price
itself. In particular, it does not depend on the random prices of other securities or
portfolios, such as the market portfolio containing all securities in the economy
Finally, observe that p ≡ (r – d)/(u – d) is always greater than zero and less than
one, so it has the properties of a probability. In fact, p is the value q would have in
equilibrium if investors were risk-neutral. To see this, note that the expected rate of
return on the stock would then be the riskless interest rate, so

Hence, the value of the call can be interpreted as the expectation of its discounted
future value in a risk-neutral world. It can be shown that Δ ≥ 0 and B ≤ 0, so the
hedging portfolio is equivalent to a particular levered long position in the stock. In
equilibrium, the same is true for the call.
Now we can consider the next simplest situation: a call with two periods
remaining before its expiration date. In keeping with the binomial
process, the stock can take on three possible values after two periods,
Cuu stands for the value of a call two periods from the current time if the stock price
moves upward each period; Cdu and Cdd have analogous definitions.
At the end of the current period there will be one period left in the life of the call, and
we will be faced with a problem identical to the one we just solved. Thus, from our
previous analysis, we know that when there are two periods left,

Again, we can select a portfolio with ΔS in stock and B in bonds whose end-of-period
value will be Cu if the stock price goes to uS and Cd if the stock price goes to dS.
Indeed, the functional form of Δ and B remains unchanged. To get the new values of Δ
and B, we simply use equation (1) with the new values of Cu and Cd.
Since Δ and B have the same functional form in each period, the current value of the
call in terms of Cu and Cd will again be C = [pCu + (1 – p)Cd]/r if this is greater than S
– K, and C =S – K otherwise. By substituting from equation (4) into the former
expression, and noting that Cdu = Cud, we obtain
A little algebra shows that this is always greater than S – K if, as assumed, r is always
greater than one, so this expression gives the exact value of the call.
All of the observations made about formula (3) also apply to formula (5), except that
the number of periods remaining until expiration, n, now emerges clearly as an
additional determinant of thecall value. For formula (5), n = 2. That is, the full list of v
ariables determining C is S, K, n, u, d, and r.
We now have a recursive procedure for finding the value of a call with any number of
periods to go. By starting at the expiration date and working backwards, we can write
down the general valuation formula for any n:
This gives us the complete formula, but with a little additional effort we can express it
in a more convenient way.
Let a stand for the minimum number of upward moves that the stock must make over
the next n periods for the call to finish in-the-money. Thus a will be the smallest non-
negative integer such that . By taking the natural logarithm of both sides
of this inequality, we could write a as the smallest non-negative integer greater than
Of course, if a > n, the call will finish out-of-the-money even if the stock moves
upward every period, so its current value must be zero.
By breaking up C into two terms, we can write

Now, the latter bracketed expression is the complementary binomial distribution

function φ[a; n, p]. The first bracketed expression can also be interpreted as a
complementary binomial distribution function φ[a; n, p′], where
In summary:





S, uS, dS, C=?
Let C be the current value of the call, Cu be its value at the end
of the period if the stock price goes to uS and Cd be its value at
the end of the period if the stock price goes to dS.
We build a replication (clone) of our option.
Suppose we form a portfolio containing Δ shares of stock and the
dollar amount B in riskless bonds. This will cost ΔS + B. At the
end of the period, the value of this portfolio will be
Since we can select Δ and B in any way we wish, suppose we
choose them to equate the end-of-period values of the portfolio
and the call for each possible outcome. This requires that

Solving these equations, we find

Summing up all of this, we conclude that if there are to be no
riskless arbitrage opportunities, it must be true that

Equation (2) can be simplified by defining

so that we can write

This formula has a number of notable features. First, the

probability q does not appear in the formula. This means,
surprisingly, that even if different investors have different
subjective probabilities about an upward or downward
movement in the stock, they could still agree on the relationship
of C to S, u, d, and r.
Second, the value of the call does not depend on investors’
attitudes toward risk.
Third, the only random variable on which the call value depends
is the stock price itself. In particular, it does not depend on the
random prices of other securities or portfolios, such as the
market portfolio containing all securities in the economy.
In fact, p is the value q would have in equilibrium if investors
were risk-neutral. To see this, note that the expected rate of
return on the stock would then be the riskless interest rate, so
Hence, the value of the call can be interpreted as the expectation
of its discounted future value in a risk-neutral world. It can be
shown that Δ ≥ 0 and B ≤ 0, so the hedging portfolio is
equivalent to a particular levered long position in the stock. In
equilibrium, the same is true for the call.
Thus, from our previous analysis, we know that when there are
two periods left,
Again, we can select a portfolio with ΔS in stock and B in bonds
whose end-of-period value will be Cu if the stock price goes to
uS and Cd if the stock price goes to dS.
By substituting from equation (4) into the former expression,
and noting that Cdu = Cud, we obtain
We now have a recursive procedure for finding the value of a
call with any number of periods to go. By starting at the
expiration date and working backwards, we can write down the
general valuation formula for any n:
We now wish to confirm that our binomial formula converges to
the Black-Scholes formula when t is divided into more and more
subintervals, and rˆ , u, d, and q are chosen in the way we
described — that is, in a way such that the multiplicative
binomial probability distribution of stock prices goes to the
lognormal distribution.
 LECTURE 6 April 2015

Wiener Processes and Itô’s Lemma

16
9
 Norbert Wiener (1894 – 1964)
17
0
 Fischer Black Myron S. Scholes Robert C. Merton

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1
 Stochastic Processes

 Describes the way in which a variable such as a

stock price, exchange rate or interest rate changes
through time
 Incorporates uncertainties

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2
 Stochastic character of stock prices

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3
17
4
 Stochastic character of indices

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5
 Example 1

 Each day a stock price

– increases by $1 with probability 30%
– stays the same with probability 50%
– reduces by $1 with probability 20%

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6
 Example 2

Each day a stock price change is drawn from a

normal distribution with mean $0.2 and
standard deviation $1

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7
 Markov Processes
(See Hull, pages 280-81)

 In a Markov process future movements in a

variable depend only on where we are, not the
history of how we got to where we are
 Is the process followed by the temperature at a
certain place Markov?
 We assume that stock prices follow Markov
processes

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8
 Weak-Form Market Efficiency

 This asserts that it is impossible to produce

consistently superior returns with a trading
rule based on the past history of stock prices.
In other words technical analysis does not
work.
 A Markov process for stock prices is
consistent with weak-form market efficiency

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9
 Example

 A variable is currently 40
 It follows a Markov process
 Process is stationary (i.e. the parameters of
the process do not change as we move
through time)
 At the end of 1 year the variable will have a
normal probability distribution with mean 40
and standard deviation 10
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0
 Questions

 What is the probability distribution of the

stock price at the end of 2 years?
 ½ years?
 ¼ years?
 Dt years?

Taking limits we have defined a continuous

stochastic process
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1
 Variances & Standard Deviations

 In Markov processes changes in successive

periods of time are independent
 This means that variances are additive
 Standard deviations are not additive

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2
 A Wiener Process
(See Hull, pages 282-84)

 Define f(m,v) as a normal distribution with

mean m and variance v

 A variable z follows a Wiener process if

– The change in z in a small interval of time Dt is
Dz
–
– The values of Dz for any 2 different (non-
overlapping) periods of time are independent
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3
 Properties of a Wiener Process

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4
 Generalized Wiener Processes
(See Hull, page 284-86)

 A Wiener process has a drift rate (i.e.

average change per unit time) of 0 and a
variance rate of 1
 In a generalized Wiener process the drift rate
and the variance rate can be set equal to any
chosen constants

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5
 Generalized Wiener Processes
(continued)

 Mean change in x per unit time is a

 Variance of change in x per unit time is b2

18
6
 Taking Limits . . .

 What does an expression involving dz and dt

mean?
 It should be interpreted as meaning that the
corresponding expression involving Dz and
Dt is true in the limit as Dt tends to zero
 In this respect, stochastic calculus is
analogous to ordinary calculus

18
7
 The Example Revisited

 A stock price starts at 40 and has a probability

distribution of f(40,100) at the end of the year
 If we assume the stochastic process is Markov with
no drift then the process is
dS = 10dz
 If the stock price were expected to grow by $8 on
average during the year, so that the year-end
distribution is f(48,100), the process would be
dS = 8dt + 10dz
18
8
 Itô Process (See Hull, pages 286)

 In an Itô process the drift rate and the

variance rate are functions of time
dx=a(x,t) dt+b(x,t) dz
 The discrete time equivalent

is true in the limit as Dt tends to

zero
18
9
 Why a Generalized Wiener Process Is
Not Appropriate for Stocks

 For a stock price we can conjecture that its

expected percentage change in a short
period of time remains constant (not its
expected actual change)
 We can also conjecture that our uncertainty
as to the size of future stock price
movements is proportional to the level of the
stock price
19
0
 An Ito Process for Stock Prices
(See Hull, pages 286-89)

where m is the expected return s is the

volatility.
The discrete time equivalent is

The process is known as geometric

19 Brownian motion
1
 Interest Rates

 What would be a reasonable stochastic

process to assume for the short-term interest
rate?

19
2
 Monte Carlo Simulation

 We can sample random paths for the stock

price by sampling values for e
 Suppose m= 0.15, s= 0.30, and Dt = 1 week
(=1/52 or 0.192 years), then

19
3
 Monte Carlo Simulation – Sampling
one Path (See Hull Table 13.1, page 289)

19
4
 Correlated Processes

Suppose dz1 and dz2 are Wiener processes

with correlation r
Then

19
5
 Itô’s Lemma (See Hull pages 291)

 If we know the stochastic process followed

by x, Itô’s lemma tells us the stochastic
process followed by some function G (x, t )
 Since a derivative is a function of the price of
the underlying asset and time, Itô’s lemma
plays an important part in the analysis of
derivatives

19
6
 Taylor Series Expansion

 A Taylor’s series expansion of G(x, t) gives

19
7
 Ignoring Terms of Higher Order
Than Dt

19
8
 Substituting for Dx

19
9
 Substituting for Dx

20
0
 The e2Dt Term

20
1
 Taking Limits

20
2
 Application of Ito’s Lemma
to a Stock Price Process

20
3
 Examples

20
4
 LECTURE 7 APRIL 2015

20
5
 The Stock Price Assumption
 Consider a stock whose price is S
 In a short period of time of length Dt, the
return on the stock is normally distributed:

where m is expected return and s is volatility

20
6
 The Lognormal Property
(Equations 14.2 and 14.3, page 300)

 It follows from this assumption that

 Since the logarithm of ST is normal, ST is

lognormally distributed
20
7
 The Lognormal Distribution

20
8
 Continuously Compounded Return
(Equations 14.6 and 14.7, page 302)

If x is the realized continuously compounded

return

20
9
 The Expected Return

 The expected value of the stock price is S0emT

 The expected return on the stock is
m – s 2/2 not m

This is because

are not the same

21
0
 m and m −s 2/2

 m is the expected return in a very short time,

Dt, expressed with a compounding frequency
of Dt
 m −s2/2 is the expected return in a long
period of time expressed with continuous
compounding (or, to a good approximation,
with a compounding frequency of Dt)

21
1
 Mutual Fund Returns (See Business
Snapshot 14.1 on page 304)

 Suppose that returns in successive years are 15%,

20%, 30%, −20% and 25% (ann. comp.)
 The arithmetic mean of the returns is 14%
 The returned that would actually be earned over the
five years (the geometric mean) is 12.4% (ann.
comp.)
 The arithmetic mean of 14% is analogous to m
 The geometric mean of 12.4% is analogous to
m−s2/2
21
2
 The Volatility

 The volatility is the standard deviation of the

continuously compounded rate of return in 1
year
 The standard deviation of the return in a
short time period time Dt is approximately
 If a stock price is $50 and its volatility is 25%
per year what is the standard deviation of the
price change in one day?
21
3
 Estimating Volatility from
Historical Data (page 304-306)

1. Take observations S0, S1, . . . , Sn at intervals

of t years (e.g. for weekly data t = 1/52)
2. Calculate the continuously compounded
return in each interval as:

3. Calculate the standard deviation, s , of the

ui´s
21 4. The historical volatility estimate is:
4
 Nature of Volatility

 Volatility is usually much greater when the

market is open (i.e. the asset is trading) than
when it is closed
 For this reason time is usually measured in
“trading days” not calendar days when
options are valued
 It is assumed that there are 252 trading days
in one year for most assets
21
5
 Example

 Suppose it is April 1 and an option lasts to

April 30 so that the number of days
remaining is 30 calendar days or 22 trading
days
 The time to maturity would be assumed to be
22/252 = 0.0873 years

21
6
 The Concepts Underlying Black-
Scholes-Merton

 The option price and the stock price depend

on the same underlying source of uncertainty
 We can form a portfolio consisting of the
stock and the option which eliminates this
source of uncertainty
 The portfolio is instantaneously riskless and
must instantaneously earn the risk-free rate
 This leads to the Black-Scholes-Merton
21
differential equation
7
 The Derivation of the Black-
Scholes Differential Equation

21
8
 The Derivation of the Black-Scholes
Differential Equatio continued

21
9
 The Derivation of the Black-Scholes
Differential Equation continued

22
0
 The Differential Equation

 Any security whose price is dependent on the

stock price satisfies the differential equation
 The particular security being valued is
determined by the boundary conditions of the
differential equation
 In a forward contract the boundary condition is
ƒ = S – K when t =T
 The solution to the equation is
22 ƒ = S – K e–r (T – t )
1
 The Black-Scholes-Merton
Formulas (See pages 313-315)

22
2
 The N(x) Function

 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

22
3  See tables
 Properties of Black-Scholes Formula

 As S0 becomes very large c tends to S0 – Ke-rT

and p tends to zero
 As S0 becomes very small c tends to zero and
p tends to Ke-rT – S0
 What happens as s becomes very large?
 What happens as T becomes very large?

22
4
 Risk-Neutral Valuation

 The variable m does not appear in the Black-

Scholes-Merton differential equation
 The equation is independent of all variables
affected by risk preference
 The solution to the differential equation is
therefore the same in a risk-free world as it
is in the real world
 This leads to the principle of risk-neutral
22
valuation
5
 Applying Risk-Neutral Valuation

1. Assume that the expected return from the

stock price is the risk-free rate
2. Calculate the expected payoff from the
option
3. Discount at the risk-free rate

22
6
 Valuing a Forward Contract with
Risk-Neutral Valuation

 Payoff is ST – K
 Expected payoff in a risk-neutral world is
S0erT – K
 Present value of expected payoff is
e-rT[S0erT – K]=S0 – Ke-rT

22
7
22
8
 Implied Volatility

 The implied volatility of an option is the

volatility for which the Black-Scholes price
equals the market price
 There is a one-to-one correspondence
between prices and implied volatilities
 Traders and brokers often quote implied
volatilities rather than dollar prices

22
9
 The VIX S&P500 Volatility Index

23
0
 An Issue of Warrants & Executive
Stock Options

 When a regular call option is exercised the stock that

is delivered must be purchased in the open market
 When a warrant or executive stock option is
exercised new Treasury stock is issued by the
company
 If little or no benefits are foreseen by the market the
stock price will reduce at the time the issue of is
announced.
 There is no further dilution (See Business Snapshot
14.3.)
23
1
 The Impact of Dilution

 After the options have been issued it is not

necessary to take account of dilution when
they are valued
 Before they are issued we can calculate the
cost of each option as N/(N+M) times the
price of a regular option with the same terms
where N is the number of existing shares and
M is the number of new shares that will be
created if exercise takes place
23
2
 Dividends

 European options on dividend-paying stocks

are valued by substituting the stock price less
the present value of dividends into Black-
Scholes
 Only dividends with ex-dividend dates during
life of option should be included
 The “dividend” should be the expected
reduction in the stock price expected
23
3
 American Calls

 An American call on a non-dividend-paying

stock should never be exercised early
 An American call on a dividend-paying stock
should only ever be exercised immediately
prior to an ex-dividend date
 Suppose dividend dates are at times t1, t2,
…tn. Early exercise is sometimes optimal at
time ti if the dividend at that time is greater
than
23
4
 Black’s Approximation for Dealing with
Dividends in American Call Options

Set the American price equal to the maximum

of two European prices:
1. The 1st European price is for an option
maturing at the same time as the American
option
2. The 2nd European price is for an option
maturing just before the final ex-dividend
date
23
5