FINA 3203

Bionominal Tree
Binomial Tree
O Dynamic replication (delta hedging)

O Risk-neutral pricing

O Calculating Risk-neutral probability

O Used for Europe and American options

(pay attention to which type in the question)

Dynamic Replication:
when long ∆ shares and short 1 call, option values = − 𝐶 + ∆𝑆
If the strike price = %21, and stock ptice in 3 months may be $18 (option price =$0) or $22
(option price =$1), the portfolio is riskless when:
22∆ -1 = 18∆
∆ = 0.25
=> 22(0.25)-1 =4.5
−00.12(0.25)
− 𝐶 + ∆𝑆 = 4. 5 * 𝑒 -> C = 0.633

Replicating call option:

𝐶 = 𝑆 + 𝑃 − 𝑃𝑉(𝐾)
𝐶 = ∆𝑆 − 𝐵

Risk-neutral pricing
In the risk-neutral world, the expected payoff discounted at
a risk-free rate with the probability p
Step 1) find p
Step 2) find f

Choose a volatility level (σ) to calculate the up and down

returns
σ Λ𝑡
𝑢 =𝑒
−σ Λ𝑡
𝑑 = 1/𝑢 = 𝑒
Generalization:
f = the value of an option on the stock
𝑓𝑢 −𝑓𝑑
∆ = 𝑆0 𝑢 − 𝑆0 𝑑

Value of the riskless portfolio at time T = 𝑆0 𝑢∆ − 𝑓𝑢

−𝑟𝑇
Value of the riskless portfolio today = (𝑆0 𝑢∆ − 𝑓𝑢 )𝑒 —1
Another expression for the portfolio value today = 𝑆0 ∆ − 𝑓 — 2
−𝑟𝑇
1=2, so: 𝑓 = 𝑆0 ∆ − (𝑆0 𝑢∆ − 𝑓𝑢 )𝑒

𝑟𝑇
−𝑟𝑇 𝑒 −𝑑
𝑓 = [𝑝𝑓𝑢 + (1 − 𝑝)𝑓𝑑]𝑒 , where 𝑝 = 𝑢−𝑑
−𝑟𝑇
𝑆 = [𝑝𝑆𝑢 + (1 − 𝑝)𝑆𝑑]𝑒

Stock Return Modeling

Historical volatility

Other types of underlying:

𝑎−𝑑
𝑝= 𝑢−𝑑
∆𝑡 = 𝑇/𝑁
N: no. of steps; T: length of each steps
𝑟∆𝑡
For non-dividend paying stock: 𝑎 = 𝑒
(𝑟−𝑞)∆𝑡
For stock index where q is the dividend yield on the index: 𝑎 = 𝑒
(𝑟−𝑟𝑓)∆𝑡
For a currency where 𝑟𝑓 is the foreign riskfree rate: 𝑎 = 𝑒
For future contract: a =1

Black-Scholes-Merton Model
Black-Scholes

O Calculation of annualized volatility: σ = 𝑆𝐷 𝑥 252 or ∆𝑡

O Calculate prices using Black-Scholes or Black’s Model

O What is VIX index:
- Expected volatility in the coming 30 days
- “Fear gauge”: when the market is afraid, it anticipates higher volatility in the future

O Volatility smile, and what drives its shape:

- relationship between implied volatility and strike price for options
- European call and put should be exactly the same
- American options are similar

Black’s Model

O Calculate implied forward price from call and put options

O Forward price model (borrowing cost)

✅
✅ Strike price (K)

✅Risk-free rate (𝑟 /𝑟) continuously compounded interest rate

Time to maturity (T)

✅
✅ Current Stock price (S)
𝑓

Estimtate of future volatility (σ)

=> black-scholes formula
=> Option price

Black-Scholes Formula

−𝑟𝑇
𝑐 = 𝑆0𝑁(𝑑1) − 𝐾𝑒 𝑁(𝑑2) S⬆-> d1⬆ -> p⬆-> c⬆
−𝑟𝑇 d1 ⬆-> d2⬆
𝑝 = 𝐾𝑒 𝑁(− 𝑑2) − 𝑆0 𝑁(− 𝑑1) R⬆ -> c⬆
Where
2
𝑙𝑛(𝑆0/𝐾) + (𝑟+σ /2)𝑇
𝑑1 =
σ 𝑇

𝑑2 = 𝑑1 − σ 𝑇
−𝑟𝑇
For dividen paying stock, 𝑆0 = 𝑆0 − 𝐷𝑒

Meaning of N(𝑑1) and N(𝑑2)

N(d2): the risk neutral probability that the call is exercised, so the expected neutral probability:
−𝑟𝑇
− 𝐾𝑒 𝑁(𝑑2)
Implied Volatility(σ)
The market’s expected volatility from now until maturity
Measure the expensiveness of the option

Black’s Model
−𝑟𝑇
𝑐 = 𝑒 [𝐹0𝑁(𝑑1) − 𝐾𝑁(𝑑2)]
−𝑟𝑇
𝑝 =𝑒 [𝐾𝑁(− 𝑑2) − 𝐹0𝑁(− 𝑑1)]
2
𝑙𝑛(𝐹0/𝐾) + σ 𝑇/2
𝑑1 =
σ 𝑇

𝑑2 = 𝑑1 − σ 𝑇

Where,
Futures: 𝐹0
(𝑟−𝑞)𝑇
Equity index: 𝐹0 = 𝑆0𝑒
(𝑟−𝑟𝑟)𝑇
Currency: 𝐹0 = 𝑆0𝑒
𝑟𝑇
Dividend-paying stock: 𝐹0 = [𝑆0 − 𝑃𝑉(𝐷)]𝑒

Pricing Options on other underlying assets (European):

ATM option: F0=K
−𝑟𝑇
Lower bound for calls: 𝑐 ≥ 𝑚𝑎𝑥[(𝐹0 − 𝐾)𝑒 , 0]
−𝑟𝑇
Lower bound for puts: 𝑝 ≥ 𝑚𝑎𝑥[(𝐾 − 𝐹0)𝑒 , 0]
−𝑟𝑇
Put-call parity: 𝑐 − 𝑝 = (𝐹0 − 𝐾)𝑒

Gpt:
Separately calculate the PV of index price (with dividend yield) and PV of strike price (with rf)

Greeks

Delta-Hedging
O Understand PNL from delta-hedging (depends on gamma and realized vol)
Cost of delta hedging ⬆when volatility ⬆
O Black-Scholes price is the expected PNL from delta-hedging continuously

Futures Option

O How settlement works for calls and puts

Greeks
O What are Delta, Gamma, Vega, Theta, Rho

Call Delta – Put Delta = 1

Delta
the rate of change of the option price with respect to small movement in the underlying
- ⬆delta -> ⬆ sensitivity to underlying assets
Delta of European call on non-dividend paying stock: 𝑁(𝑑1)
Delta of a European put: 𝑁(𝑑1) − 1 or − 𝑁(− 𝑑1)

Theta
rate of change of the option value with respect to the passage of time
- Often quoted in days
- Not risky as no uncertainty about time
- Theta of long option position is negative (time decay and greatest for ATM options)
- Larger when the expected volatility is higher

Gamma
Rate of change of delta with respect to the price of the underlying asset (bet on the future
realised volatility)
⬆ gamma -> delta changes rapidly -> greater delta-hedging errors
Low IV -> larger gamma for ATM and lower gamma for ITM & OTM options
- Long position: +ve gamma
- Short position: -ve gamma
- Stock position: gamma = 0
- ATM options have the greatest amount of gamma
The amount of gain/loss from gamma depends on the realised volatility of the underlying asset

Vega
Rate of change of the value of a derivatives portfolio with respect to volatility (bet on the
direction of the future expected volatility)
e.g. vega - 12 (per 1%)
When IV changes by +1%, option value changes by +$12
 - Long option position: +ve vega
- Short option position: -ve vega
- Stock position: vega = 0
- ATM got the greatest amount of vega
- IV ⬆-> vega for ITM & OTM ⬆
- Maturity approaches -> vega for option decreases -> long-dated options are more
sensitive to changes in expected volatility

Rho

The rate of change of the value of a derivative with respect to the interest rate
Not a significant risk as: 1) interest rate changes are small 2) interest rate changes are
infrequent

Greeks in portfolio
Changes in value of a portfolio (∆Π)
2
∆Π = 𝐷𝑒𝑙𝑡𝑎 * ∆𝑆 + 𝑉𝑒𝑔𝑎 * ∆σ + 𝑇ℎ𝑒𝑡𝑎 * ∆𝑡 + 0. 5𝑔𝑎𝑚𝑚𝑎 * (∆𝑆) +...
∆𝑆 : not in % but in dollar amount

O What are their signs for different long and short option positions

O Portfolio level Greeks

O Estimate portfolio value changes using Greeks

Note: Even if all else remains constant, there’s still effect from Theta

O Hedging Delta, Gamma, Vega using underlying asset and options

Other Derivatives (only in MC and Short Questions)

O Interest Rate Swaps

How are they used to hedge assets and liabilities

How to add up interest inflows and outflows
Identifying Comparative Advantage

O CDS
Pricing and Settlement methods
CBS spread = bond yield - riskfree rate

O Currency Swaps , Warrant, CBBC, ELN

How do they work?
Pricing of CBBC

Gpt:

Currency Swaps
Currency swaps are financial agreements between two parties to exchange
principal and interest payments in different currencies. Here’s how they
work:
1. Initial Exchange: At the beginning of the contract, the parties
exchange equivalent amounts of principal in different currencies. For
example, Company A in the U.S. might exchange $1 million with
Company B in Japan for an equivalent amount in Japanese yen.
2. Interest Payments: Throughout the term of the swap, each party pays
interest on the principal received in the exchange. For instance, if the
swap involves USD and JPY, Company A pays interest in yen to
Company B, and Company B pays interest in dollars to Company A.
3. Final Exchange: At the end of the contract, the parties re-exchange the
principal amounts at the original exchange rate. So, Company A will
return the yen to Company B and receive back its $1 million.
Example:
● Company A (USD) and Company B (JPY) agree on a currency swap.
● Initial exchange: $1 million (Company A) ↔ ¥110 million (Company B).
● Interest payments: Company A pays 3% on ¥110 million in yen,
Company B pays 2.5% on $1 million in dollars.
● At maturity, they re-exchange the principal amounts: ¥110 million ↔
$1 million.
●

Warrants
Warrants are derivatives that give the holder the right, but not the obligation,
to buy or sell a security—typically stock—at a specific price before expiration.
1. Issued by Companies: Unlike options, which are usually issued by third
parties, warrants are often issued by the company itself.
2. Exercise Price: The price at which the warrant holder can buy (call
warrant) or sell (put warrant) the underlying asset.
3. Expiration: Warrants have an expiration date, after which they become
worthless if not exercised.
Example:
● A company issues a warrant allowing the holder to buy its stock at $50
 per share.
● If the stock price rises to $70, the holder can buy at $50, making a
profit.
● If the stock price stays below $50, the warrant is not exercised.
Callable Bull/Bear Contracts (CBBC)
CBBCs are similar to options but with a knock-out feature that can render
them worthless if certain conditions are met.
1. Bull Contracts: These benefit from rising prices. They are knocked out
if the underlying price falls to a specified call price.
2. Bear Contracts: These benefit from falling prices. They are knocked
out if the underlying price rises to a specified call price.
3. Payoff: If not knocked out, the payoff is the difference between the
underlying price and the strike price at maturity.
Example:
● A bull CBBC on a stock with a strike price of $100 and a call price of
$90.
● If the stock price stays above $90, the holder gets the difference
between the stock price and $100 at maturity.
● If the stock drops to $90, the contract is knocked out and becomes
worthless.
Equity-Linked Notes (ELN)
ELNs are debt instruments with returns linked to the performance of an
equity or a basket of equities.
1. Fixed Interest: ELNs pay a fixed interest over the life of the note.
2. Equity Component: At maturity, the investor may receive the return
based on the performance of the underlying equity.
3. Principal Risk: The principal repayment can be less than the initial
investment if the equity performs poorly.
Example:
● An ELN linked to the stock of Company X.
● Pays 5% interest annually.
● At maturity, if Company X's stock price is above a certain level, the
investor gets the principal plus a return based on the stock price.
● If the stock performs poorly, the investor may get back less than the
principal amount.