# Financial Options: Pricing and Hedging

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1 Financial Options: Pricing and Hedging Diagrams Debt Equity Value of Firm s Assets T Value of Firm s Assets T Valuation of distressed debt and equity-linked securities requires an understanding of financial options

2 Example: Call Option Equity C Max(S T -K,0) K Stock Price T Three approaches to valuation: 1. Binomial Model 2. Black Scholes 3. Monte-Carlo Analysis Option Valuation Methods Easy to implement Black Scholes Binomial Monte Carlo Difficult to implement Flexible Inflexible

3 Binomial Option Pricing Stock Price Tree Stock Up p=0.5 (1-p)=0.5 E(S T ) = 100 Stock Down 90 What is the value of a call option with a strike price of \$100? (Assume r = 0%)

4 Call Option Tree C t Stock Up p=0.5 (1-p)= E( T ) = 5 Stock Down 0 Incorrect Approach: C = (0.5)(10) + (0.5)(0) = \$5.00 Why Is This Wrong? Simply discounting the probability weighted average of option payoffs does not properly control for risk. If we were operating in a risk-neutral world, the above approach would be fine.» In a risk neutral world, the market risk premium is 0%, not 7.5%. But in a risk-neutral world, the stock price would be \$100 (= (0.5)(110)+(0.5)(90)), not \$95.

5 Correct Approach: Replicating Portfolio Stock Up p= B(1+r f ) S t -B (1-p)=0.5 Stock Down 90 -B(1+r f ) Replicating Portfolio: 1. Buy shares of stock 2. Borrow \$B Cost of Portfolio = S t -B Correct Approach: Replicating Portfolio Stock Up p=0.5 S t -B (1-p)=0.5 Stock Down 110 -B(1+r f ) = B(1+r f ) = 0 Two Equations: B(1+rf) = B(1+rf) = 0 Solving yields =0.5 and B=45

6 No Arbitrage: Law of One Price The replicating portfolio has payoffs that are identical to payoffs from the call option in every state of the world (e.g. stock price up versus stock price down). Therefore, to prevent arbitrage, the price of the replicating portfolio must equal the price of the call option. C = S t -B = (0.5)(95)-45 = \$2.50 (not \$5.00) Alternative Approach: Risk Neutral Probabilities Notice that the Replicating Portfolio approach did not require knowledge of investors risk aversion Therefore, the Replicating Portfolio approach will work for all levels of risk aversion In particular, it will work when investors are riskneutral (e.g. market risk premium = 0%, not 7.5%) Risk-neutral probabilities are those that would have to exist to support observed prices in a risk-neutral world

7 Stock Price Tree Stock Up p=0.5 (1-p)=0.5 E(S T ) = 100 Stock Down 90 The risk-neutral probability, p, satisfies the following equation: 95 = [(p)(110)+(1-p)(90)]e -rt p = 0.25 Call Option Tree Stock Up 10 C t p=0.25 (1-p)=0.75 E( T ) = 5 Stock Down 0 C = [(0.25)(10) + (0.75)(0)]e -rt = \$2.50 (recall r=0% by assumption)

8 Multi-period Binomial Trees Desired features of tree» We would like it to be recombining The stock price if it first goes up and then goes down should be the same as the stock price if it first goes down and then goes up» We would like the resulting distribution of stock returns to be similar to observed distributions (e.g. approximately normal) Define the following (µ=expected stock return, F=standard deviation of stock return, t=size of time step,*=dividend yield) σ u = e t σ d = e t (r δ) e d p= u d 10-Period Example Value a call option with the following parameters:» Time until maturity = 1 year» Standard deviation of stock returns = 30%» Strike price = \$100» Stock price = \$95» Dividend yield = 1%

9 Stock Price Tree Current Stock Price \$95.00 Sigma*Sqrt(T) Dividend Yield 1.00% Probability Up Volatility 30.00% Probability Dow n Risk-free rate 5.00% Up Time Step (years) 0.1 Dow n Strike Price 100 p=[exp((r-divyld)dt)-d]/[u-d] =(1-p) exp(sigma*sqrt(dt)) exp(-sigma*sqrt(dt)) Call Option Value Delta /7/2001 3/15/2001 4/21/2001 5/27/2001 7/3/2001 8/8/2001 9/14/ /20/ /26/2001 1/1/2002 2/7/ Call Price Tree 2/7/2001 3/15/2001 4/21/2001 5/27/2001 7/3/2001 8/8/2001 9/14/ /20/ /26/2001 1/1/2002 2/7/ =[(p)(call Up)+(1-p)(Call Down)]*exp(-rT) Max(ST-K,0)

10 Black Scholes Option Value C= S T N(d Ke rt t e δ 1 ) N(d 2 ) σ 2 ln(s t / K) + (r δ + )T d 2 1 = σ T d 2 = d 1 σ T Variables» S t : Current stock price» *: Dividend yield (annual \$ dividend/current stock price)» T: Time until expiration» N(): Cumulative normal function» K: Exercise price» R: Risk-free rate» F: Volatility (standard deviation of stock returns) Assumptions» Frictionless financial markets» Assets are perfectly divisible» No restrictions on short sales» Borrow and lend at the same interest rate» Interest rate is constant» Stock prices follow a continuous path -- i.e. there are no jumps» Stock s expected return and the variance are constant over the life of the option» The continuously compounded return over any period is normally distributed: Example 10-Period Binomial» Call Price = \$10.90» Delta = Period Binomial Model» Call Price = \$10.76» Delta = 0.54 Black-Scholes Model» Call Price = \$10.75» Delta = 0.54

11 Delta Hedging Delta Hedging: Convex C Tangent Line, Slope = S t Stock Price T Portolio: 1. Long 1Call Option 2. Short shares of stock: C Call = = e δt N(d 1 ) St

12 Delta Hedging Profits: Stock Price Increase Gain on long Loss on short (= ε) S t S t +ε S t S t +ε Gain on Long > Loss on Short Delta Hedging Profits: Stock Price Decrease S t- ε Gain on short S t Loss on long S t -ε S t Gain on Short > Loss on Long

13 Convexity Positive profits are made when:» Stock price increases» Stock price decreases Since convexity is good, you must pay for it» Option premium» Time decay Convex payoff schedules have positive gamma 2 e δt C N'(d 1 ) CallΓ= = = 2 S t St Stσ T Delta Hedging: Concave Tangent Line, Slope = P S t Portfolio: 1. Short one put option 2. Short shares of stock Stock Price T

14 Delta Hedging Profits: Stock Price Increase S t S t +ε Loss on stock S t S t + ε Gain on put Gain on put < Loss on stock Delta Hedging Profits: Stock Price Decrease S t -ε S t S t -ε Loss on put Gain on stock S t Loss on put > Gain on stock

15 Concavity Negative profits are made when:» Stock price increases» Stock price decreases Unattractive features of concavity are compensated by» Option premium (you receive the premium)» Time decay Concave payoff schedules have negative gamma 2 e δt C N'(d 1 ) CallΓ= = = 2 S t St Stσ T Portfolios of Options \$50 Slope = 1.0 Slope = 0.5 \$50 \$100 Stock Price T Replicating Portfolio: 1. Long one share of stock 2. Short one call option with strike of \$50 3. Long 0.5 call options with strike of \$100

16 Example Assumptions» S t = \$95 (current stock price)» * = 1.0% (dividend yield)» T = 1.0 years (time until expiration)» r = 5.0% (risk-free rate)» F = 30% (standard deviation of stock returns) Portfolios of Options \$50 Slope = 0.29 \$95 Stock Price T Quantity Price Delta Gamma Stock Short Call, X=\$50 (46.57) (0.98) (0.0007) Long Call, X=\$ Price Delta Gamma Total

17 Portfolios of Options \$50 Slope = 0.29 \$95 Stock Price T Quantity Price Delta Gamma Price Delta Gamma Stock Short Call, X=\$ (46.57) (0.98) (0.0007) (46.57) (0.98) (0.0007) Long Call, X=\$ Less PV of Dividends 1.00 (0.91) - - (0.91) - - Total Alternative Replicating Portfolio \$50 Slope = 1.0 Slope = 0.5 \$50 \$100 Stock Price T Alternative Replicating Portfolio:

18 Portfolios of Options \$50 Slope = 0.29 \$95 Stock Price T Quantity Price Delta Gamma Price Delta Gamma (0.08) 0.01 (0.00) Total Portfolios of Options \$50 Slope = 0.29 \$95 Stock Price T Quantity Price Delta Gamma Price Delta Gamma Long risk-free bond Short Put, X=\$ (0.08) 0.01 (0.00) (0.08) 0.01 (0.0007) Long Call, X=\$ Total

19 Gamma Hedging Example Assumptions» S t = \$50 (current stock price)» * = 1.0% (dividend yield)» T = 1.0 years (time until expiration)» r = 5.0% (risk-free rate)» F = 30% (standard deviation of stock returns)

20 Portfolios of Options: Negative Gamma Slope = 0.41 \$50 \$50 Stock Price T Quantity Price Delta Gamma Price Delta Gamma Stock Short Call, X=\$ (6.81) (0.61) (0.0253) (6.81) (0.61) (0.0253) Long Call, X=\$ Less PV of Dividends 1.00 (0.92) (0.92) Total (0.0236) Hedging Negative Gamma To eliminate the negative gamma in a portfolio, add a security with positive gamma In the above example, we can buy X put options with a strike price of \$50 (long put has positive gamma)» Set X such that the positive gamma from the puts exactly offsets the negative portfolio gamma XΓPut = ΓPut =.0253( from Black Scholes) X = 0.93Puts» Now adjust short to remain delta neutral Put = 0.38(fromBlack Scholes).93 Put = 0.35 Portfolio +.93 Put = = 0.06

21 Hedging Gamma-Summary Delta and Gamma Neutral Portfolio consists of» Long Original Portfolio» Long 0.93 Put Options With a Strike = \$50 and T-t = 1 year» Short 0.05 Shares of Stock Delta Gamma Long Portfolio Long.93 Puts Short.05 Shares Total Summary Big Picture» The payoff from most securities and transactions can be viewed as a portfolio of options» Value the security or transaction can be accomplished by summing the values of the individual options Mechanics» Simple Black-Scholes often provides a very good estimate of value and Greeks» Binomial models are easy to build and can easily handle most bells and whistles» Path dependency is trickier Monte Carlo methods are better suited for path-dependent situations

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