Professional Documents
Culture Documents
Spring 2007
Forwards
Put Call Parity
Spreads
A Bull Spread consists of either buying a call with strike price K 1 and selling
one with strike price K 2 > K 1 , or buying a put with strike price K 1 and selling a put
with strike price K 2 < K 1 .
A Bear Spread is the opposite of a bull spread; either for calls K 2 < K 1 or for
puts K 2 > K 1 .
−r f T
x0 e = Pre-paid forward exchange rate
( rd −r f )T
x0 e = Forward exchange rate
Currency Options
Asset = Call – Put + PV(Strike Price)
−r f T
x0 e = Call – Put + Ke −rd T
1 1 C ( x0 , K , T )
P , , T =
x0 K Kx 0
Binomial Trees
Option Price = ∆ S + B =
e [ p*Cu + (1− p*) Cd]
−r h
−δT Cu − C d −δT C u − C d uC − dC u
∆= e S (u − d ) = e S − S B= e −rT d
u d u −d
e ( r −δ ) h − d 1
p* = =
u −d 1 + eσ h
u = e ( r −δ) h +σ h d = e ( r −δ ) h −σ h
d < e ( r −δ ) h < u σ = Volatility
Alternative Binomial Trees
Cox-Ross-Rubinstein
u = eσ h
d = e −σ h
Lognormal
1 1
( r −δ − σ 2 ) h +σ h ( r −δ − σ 2 ) h −σ h
u =e 2
d =e 2
C e γh = S∆ e αh + B e rh
Black-Scholes Formula
General Black-Scholes Formula
C ( S , K , σ , r , t , δ ) = F P ( S ) N ( d1 ) − F P ( K ) N ( d 2 )
P ( S , K ,σ , r , t , δ ) = −F P ( S ) N ( −d1 ) + F P ( K ) N ( −d 2 )
where
F P (S ) 1 2
ln P + σ t
F ( K ) 2 d 2 = d1 −σ t
d1 =
σ t
where
S 1
ln + ( r − δ + σ 2 )t
K 2 d 2 = d1 −σ t
d1 =
σ t
F P ( S ) = Se −δt
F P ( K ) = Ke −rt
Black-Scholes Formula for Currency Options
C ( x0 , K , σ , rd , t , r f ) = x0 e
−r f t
N ( d1 ) − Ke −rd t N ( d 2 )
P ( x0 , K , σ , rd , t , r f ) = −x0 e
−r f t
N (−d1 ) + Ke −rd t N (−d 2 )
where
x 1
ln 0 + (rd − r f + σ 2 )t
K 2
d1 =
σ t
d 2 = d1 −σ t
Currency-Denomination
An option is currency-denominated if the strike price and premium are
denominated in that currency.
where
F 1
ln + σ 2 t
K 2 d 2 = d1 −σ t
d1 =
σ t
The pre-paid forward price for a future, is the future discounted at the risk-
free rate. δ = r
Option Greeks
∆ Delta
Delta measures the option price change when the stock price
increases by $1.
∆Call = e −δt N ( d1 ) ∆Put = −e −δt N ( −d1 )
∆Call − ∆ Put = e −δT
ΓGamma
Gamma measures the change in Delta when the stock price
increases by $1. Gamma is the convexity of the option.
d∆ d 2V
Γ= = where V is the derivative of S.
dS dS
ΓCall = ΓPut
∆ t +h − ∆ t
Γ=
ε
Vega
Vega measures the change in the option price when there is an
increase in volatility, σ , of one percentage point.
dV
Vega = * 100 where V is the derivative of S.
dσ
θ Theta
Theta measures the change in the option price when there is a
decrease in the time to maturity of one day.
dV
θ= where V is the derivative of S.
dt
ρ Rho
Rho measures the change in the option price when there is an
increase in the interest rate of one percentage point (100 basis points).
ρ = dV * 100 where V is the derivative of S.
dr
Ψ Psi
Psi measures the change in the option price when there is an
increase in the continuous dividend yield of on percentage point (100 basis
points).
dV
Ψ= * 100 where V is the derivative of S.
dδ
Option Elasticity
An option is an alternative to investing in the stock. Delta tells us the dollar risk of the
option relative to the stock: If the stock price changes by $1, by how much does the
option price change? The option elasticity, by comparison, tells us the risk of the option
relative to the stock in percentage terms: If the stock price changes by 1%, what is the
percentage change in the value of the option?
Option Volatility
σOption =σStock * Ω
Sharp Ratio
The Sharp Ratio for any asset is the ratio of the risk premium to volatility.
α −r
Sharp Ratio for Call =
σ
− (α − r )
Sharp Ratio for Put =
σ
Delta-Hedging
Overnight Profit on a Delta-Hedged Portfolio
OP = Ct − Ct +h + ∆( S t +h − S t ) − (e 365 − 1)( ∆S t − Ct )
1
OP = − Γε 2 + θ h + r h (∆ S − Ct )
2
Black-Scholes Equation
1
r C (S ) = σ 2 S 2Γ + r S ∆ + θ
2
Delta-Gamma-Theta Approximation
1
Ct +h = Ct + ε ∆t + ε 2 Γt + hθ
2
where
• C ( S t +h ) =Option Cost at time t+h
• C ( S t ) = Option Cost at time t
• ε = S t +h − S t = Change in stock price from time t to time t+h
∆( S t +h ) − ∆( S t )
• Γ( S t ) =
ε
Market Making
• A Barrier Option has a payoff which depends on whether over the lifetime of the
option the underlying asset hits the barrier. 3 Types.
1. Knock-Out Options
Up and Out
Down and Out
2. Knock-In Options
Up and In
Down and In
3. Rebate Options
Pays a fixed amount if barrier is hit.
Up Rebates
Down Rebates
• Parity Relationship for Barrier Options
Knock-In + Knock-Out = Ordinary
Compound Option