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International Derivatives Exhibition

Reech Capital

Guillaume BLACHER

Advanced Pricing and Risk

FOW Frankfurt March 7 - 8th 2000

Management for Equity Derivatives

➢ Presentation of products most actively studied in Equity Derivatives
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Guillaume BLACHER Reech Capital

➢ Evolution in pricing exotics ➢ Choosing a proper diffusion model ➢ Numerical methods: complexity and performance ➢ Generic product description tools ➢ The Future of quantitative analysis
Equity Derivatives
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products most actively studied in Equity Derivatives

info Guillaume BLACHER Reech Capital – new market conditions – new tax regimes – new corporate situation • Among most popular: – – – – Cliquets Structured notes Baskets and multi-underlying products Hybrid Products Equity Derivatives Slide 4 .Products • High variety of products in Equity Derivatives • Always new products tailored to: download at wowebook.

Cliquets • Pays the equity positive performance each Guillaume BLACHER Reech Capital • Pricing: æ STi+1 − STi ö ç ç ST i è – By Monte-Carlo: most natural but slow – By Tree/PDE: requires a second dimension for the strike • Problems: – Almost a pure volatility product – Strong impact of smile and dividends Equity Derivatives Slide 5 • Solution: pricing by static replication . defined as: + download at wowebook.

redemption) Exotic features ( Equity Derivatives Slide 6 . basket) Path dependent features (average) American style features (puttable) Guillaume BLACHER Reech Capital download at wowebook. barriers…) Swap features (equity swaps) Multi-underlying (best of.Structured notes • Client gives up risk-free return. • Often combines many features into one product: – – – – – – Bond features (coupons. dividends and/or x% of capital to get some equity exposure via embedded option.

mainly with path-dependent features (asian baskets) and capped download at Guillaume BLACHER Reech Capital • Example: 5Y basket option of 3 indices.diversified portfolio Equity Derivatives Slide 7 . with a knock-in in the first 2. • Modeling correlation realistically is crucial • Correlation cannot be hedged on a trade by trade basis (no exchange traded correlation sensitive options): need for creativity to build up a correlation .Exotics on basket • Still a lot of business on baskets.5Y at 175% to get an extra 25% of gearing.

info Guillaume BLACHER Reech Capital – Best of equity / interest rate – Interest swaps triggered by equity level – Debt products with FX components • Requires – Combination of skills for modeling heterogeneous assets together – Very high structuring and pay-off description flexibility – Consistent risk management across all asset classes Equity Derivatives Slide 8 .Hybrid products • More and more products across asset classes: download at wowebook.

info Guillaume BLACHER Reech Capital • Example: In 6M. Equity Derivatives Slide 9 . option pays the 1M at-the-money implied volatility.Volatility products • Swaps or options on: – realised volatility from start to maturity – Implied volatility download at wowebook. • Pricing mechanism differs from standard structure: – Mix of semi-static option hedge and dynamic spot hedge – Several un-hedgeable elements that need to be taken into account.

info Pricing Exotics .download at wowebook.

Pricing components • Several components in a pricing engine: Diffusion model Numerical method Guillaume BLACHER Reech Capital download at Model parameters / Calibration Product description Equity Derivatives Slide 11 .

download at Diffusion models (I) .

time) – default probability p(spot.Diffusion models • All pricings should be consistent with market prices of hedging instruments: download at wowebook. time) • Those functions can be calibrated to market instruments Equity Derivatives Slide 13 .info Guillaume BLACHER Reech Capital – Current yield – Smile – Credit curve • The least it should do to achieve this with deterministic models: – short term rate: r(time) – instantaneous volatility σ(spot.

Example: volatility modeling • The simplest diffusion consistent with a market skew is: dS = (r − repo − div )dt + σ (S . t )dWt S download at Guillaume BLACHER Reech Capital • Always exists if market prices are not arbitrageable • Would be unique if a continuum of prices were given • Significant price impact on: – Barriers – Cliquets – Basket options Equity Derivatives Slide 14 .

info Guillaume BLACHER Reech Capital Market smile 39 37 35 33 31 29 27 25 3 2.Example • Pricing with smile can be critical when the right price cannot be reach with BlackScholes formula download at wowebook.5 1 0.5 0 0% Strike Maturity Up and Out Call option Strike Maturity Black-Scholes price Smile price Flat smile 35 33 31 29 27 20% 40% 60% 25 Black-Scholes volatility Equity Derivatives Slide 15 .5 Barrier price 2 1.

Our download at wowebook. Equity Derivatives Slide 16 .info Guillaume BLACHER Reech Capital mark-to-market position would be showing a big loss (if we bought the barrier) or a big profit (if we sell the barrier) • Only makes sense if a consistent vega hedge is used.Hedging • What if the smile disappears? Black-Scholes assumption would then apply.

info Risk Management .download at wowebook.

info Guillaume BLACHER Reech Capital – Parallel shift of the 2% Classic Vega perturbation whole smile surface – No protection against deformations – Which European -1% 1% 0% options to buy as a hedge? Strike Maturity Equity Derivatives Slide 18 .Vega analysis Volatility risk can be measured at 3 levels: 1) Single vega number: download at wowebook.

Vega analysis (2) 2) Vega buckets: – Parallel shift of the skew at each tenor download at Guillaume BLACHER Reech Capital – Protection against time deformations only – Which strike should we buy as a hedge? Bucket Vega perturbation 2% Vega bucket for an exotic 1% 0% Vega -1% 1M 2M 3M 4M 5M 6M 7M Equity Derivatives Slide 19 Strike Maturity Tenor .

info Guillaume BLACHER Reech Capital – Protection against any deformation – Provides strikes and maturities to hedge with. Superbucket perturbation 2% Superbucket: Up&Out Call strike 1% barrier Vega 0% Equity Derivatives Maturity -1% Strike Mat Strike Slide 20 .Vega analysis (3) 3) Superbuckets: – Shift of each individual point on the surface download at wowebook.

Global risk management • Each individual exotic has got its superbucket topography. • What is really relevant is the superbucket of the download at Guillaume BLACHER Reech Capital whole book. aggregating exotics and vanillas on the same underlying: Sensitivities to be hedged out (by trading corresponding Europeans) Portfolio superbucket Vega Equity Derivatives Mat Strike Slide 21 .

info Time Vega Vega Traders will try to flatten the Classic Report where they should be trying to flatten the Correct Report: • Equivalent for European options • Different for Exotics Slide 22 Equity Derivatives .Risk Reports Classic Report: Spot Maturity CORRECT Report: Strike Guillaume BLACHER Reech Capital download at wowebook.

what is the cost? Equity Derivatives Slide 23 . whether they be: download at wowebook.Global risk management (2) • This (correct) analysis should be available at portfolio level on all model parameters. smile surface) – un-hedgeable (instantaneous forward correlation) • It gives today’s hedge but may not be static: need for readjusting in the future • Question: if readjusting is Guillaume BLACHER Reech Capital – hedgeable (credit term structure.

download at Diffusion models (II) .

.. To price the cost of Guillaume BLACHER Reech Capital • Volatility itself Rebalancing vega hedge will produce systematic cost/profit that can only be estimated will a stochastic volatility model. dVega dSpot dVega dVol Correlation (Spot.. Vol) Volatility of volatility Equity Derivatives Slide 25 . we need to model.Cost of hedging Some options exhibit a vega that varies with: • Spot download at wowebook..

model parameters do – Forward smiles not realistic • Although the reason for choosing a model is consistency and not ability to Guillaume BLACHER Reech Capital – Even when market does not change. the cost of rehedge will be wrongly estimated • Conclusion: try to find the model with most stable parameters Equity Derivatives Slide 26 .Stationarity • Many different ways to match current smile • Choosing the wrong model means having nonstationary parameters: download at wowebook.

download at Model parameters / Calibration .

. Slide 28 Equity Derivatives .Auto-calibrated models • Some model can be considered as auto-calibrated: “calibration” is analytical. quasi-instantaneous and happens automatically inside the numerical download at Guillaume BLACHER Reech Capital method • Examples: – Local volatility in a Black-Scholes framework – Local volatility in a deterministic volatility model – Drift of the short term rate in an Heath-Jarrow-Morton framework – Instantaneous default probability if deterministic – etc.

it is done once and for all (until market conditions change significantly) • Examples: – Parameters of stochastic volatility / jump models – Volatility in interest rate models • Systems have to be flexible enough to let the calibration process happen independently from pricing Equity Derivatives Slide 29 .Calibration • More and more advanced models are not autocalibrated • Calibration is a long process download at Guillaume BLACHER Reech Capital • On the other hand.

download at Numerical methods .

info Guillaume BLACHER Reech Capital • Trinomial trees do the job.Trees • Just a way to compute an expectation • Binomial trees obsolete (except for quick approximations) download at wowebook. although they are less efficient than PDEs. • 2-dimensional trees technology well mastered S2 spot time spot S1 time time Equity Derivatives Slide 31 Binomial Trinomial 2D Trinomial .

PDEs • Allows for implicit discretisation • More flexibility on the grid • Better performance in Guillaume BLACHER Reech Capital • 2-dimensional PDEs technology well mastered • Provides option price at any time for any spot Spot Price profile today PDE grid Pay-off for an Up&Out Call Equity Derivatives Option price Time Intrinsic value Slide 32 . much better for some products (barriers for example) download at wowebook.

8 0.4 0.5 0.1 0.3 0.3 0.5 0.7 0.1 0 0 0.9 1 1 0.4 0.7 0.6 0.7 0.9 0.8 0.1 0 0 0.4 0.2 0.3 0.1 0.6 0.2 0.2 0.2 0.8 0.9 1 Guillaume BLACHER Reech Capital download at wowebook.4 0.8 Equity Derivatives Standard MC sampling Sobol sampling Slide 33 .3 0.Monte Carlo • Low discrepancy series (ex: Sobol) provide very high convergence rate compared to standard Monte Carlo • Unfortunately biased in high dimension • Dimension reduction techniques have to be used in high dimension (spectral truncation) • Several very efficient techniques to price american style options within simulations 1 0.5 0.5 0.6 0.9 0.6 0.7 0.

• Using those instead of brutal calculation power needs structural changes in trading systems architecture. • Becomes an issue when thousands of positions have to be revalued. • Better understanding of models and numerical speed-ups should precede the purchase of highend hardware.Complexity vs Performance • More accurate models usually mean greater computation Equity Derivatives Slide 34 . Guillaume BLACHER Reech Capital download at wowebook.

download at Product description .

Equity Derivatives richness • Structured products and Derivatives have 3 main properties: 1) Extreme diversity of features download at Guillaume BLACHER Reech Capital 2) All features have to be priced together 3) Product popularity does not last forever • This means: – A lot of work for quants to implement new features in the library – Library contain high quantity of obsolete products (or even products that have never been dealt) Equity Derivatives Slide 36 .

info Guillaume BLACHER Reech Capital – spend more time improving their numerical methods • Structurers/Marketers should: – spend no time waiting for quants to come up with a new product in the Library – spend more time studying the risks of the product – spend more time trying new ideas Equity Derivatives Slide 37 • What’s the solution? A generic product description language .Generic product description • Quants should: – spend no time implementing new products in a Library – spend more time modeling the market parameters download at wowebook.

The future of quantitative analysis • Main challenge: model more sources of risk while maintaining reasonable computation speed. download at Guillaume BLACHER Reech Capital • How is it possible? – Better understanding of the products helps identifying most important factors – Some risks can be taken into account without increasing the dimension – More advanced numerical methods and numerical speed-ups are to be used Slide 38 Equity Derivatives .

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