Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

Arbitrage-FreePricingModels
LeonidKogan
MIT,Sloan
15.450,Fall2010
LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 1/48 c
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Outline
1
Introduction
2
ArbitrageandSPD
3
FactorPricingModels
4
Risk-NeutralPricing
5
OptionPricing
6
Futures
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 2/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

OptionPricingbyReplication
Theoriginalapproachtooptionpricing,goingbacktoBlack,Scholes,and
Merton,istouseareplicationargumenttogetherwiththeLawofOnePrice.
Considerabinomialmodelforthestockprice
Payoffofanyoptiononthestockcanbereplicatedbydynamictradinginthe
stockandthebond,thusthereisauniquearbitrage-freeoptionvaluation.
Problemsolved?
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 4/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
DrawbacksoftheBinomialModel
Thebinomialmodel(anditsvariants)hasafewissues.
Ifthebinomialdepictionofmarketdynamicswasaccurate,alloptionswould
beredundantinstruments.Isthatrealistic?
Empirically,themodelhasproblems:oneshouldbeabletoreplicateoption
payoffsperfectlyintheory,thatdoesnothappeninreality.
Whybuildmodelslikethebinomialmodel?Convenience.Uniqueoptionprice
byreplicationisaveryappealingfeature.
Howcanonemakethemodelmorerealistic,takingintoaccountlackof
perfectreplication?
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 5/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
ArbitrageandOptionPricing

STOCK
BOND
ARBITRAGE
ARGUMENT
OPTION
PRICE
PRICINGREDUNDANTOPTIONS
ARBITRAGE
FREEMODEL:
STOCK
BOND
OPTION
EMPIRICAL
ESTIMATION
PRICINGNONREDUNDANTOPTIONS
OPTION
PRICE

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1
2
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
ArbitrageandOptionPricing
Takeanalternativeapproachtooptionpricing.
Evenwhenoptionscannotbereplicated(optionsarenotredundant),there
shouldbenoarbitrageinthemarket.
Theproblemwithnon-redundantoptionsisthattheremaybemorethanone
valueoftheoptionpricetodayconsistentwithnoarbitrage.
Changetheobjective:constructatractablejointmodeloftheprimitiveassets
(stock,bond,etc.)andtheoptions,whichis
Freeofarbitrage;
Conformstoempiricalobservations.
Whenoptionsareredundant,noneedtolookatoptionpricedata:thereisa
uniqueoptionpriceconsistentwithnoarbitrage.
Whenoptionsarenon-redundant,theremaybemanyarbitrage-freeoption
pricesateachpointintime,soweneedtorelyonhistoricaloptionpricedata
tohelpselectamongthem.
Weknowhowtoestimatedynamicmodels(MLE,QMLE,etc.).Needtolearn
howtobuildtractablearbitrage-freemodels.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

AbsenceofArbitrage
Consideranite-horizondiscrete-timeeconomy,time={0,...,T}.
Assumeanitenumberofpossiblestatesofnature,s=1,...,N
t =0 t =1 t =2

s
1

s
2
s
3

s
4
Denition(Arbitrage)
Arbitrageisafeasiblecashow(generatedbyatradingstrategy)whichis
non-negativeineverystateandpositivewithnon-zeroprobability.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 9/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AbsenceofArbitrage
Denition(Arbitrage)
Arbitrageisafeasiblecashow(generatedbyatradingstrategy)whichis
non-negativeineverystateandpositivewithnon-zeroprobability.
Weoftendescribearbitrageasastrategywithnoinitialinvestment,noriskof
aloss,andpositiveexpectedprot.Itsaspecialcaseoftheabovedenition.
AbsenceofarbitrageimpliestheLawofOnePrice:twoassetswiththesame
payoffmusthavethesamemarketprice.
Absenceofarbitragemaybeaveryweakrequirementinsomesettingsand
quitestronginothers:
Equities:fewsecurities,manystates.Easytoavoidarbitrage.
Fixedincome:manysecurities,fewstates.Noteasytoavoidarbitrage.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 10/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AbsenceofArbitrage
FundamentalTheoremofAssetPricing(FTAP)
Proposition(FTAP)
Absenceofarbitrageisequivalenttoexistenceofapositivestochasticprocess
{
t
(s)>0}suchthatforanyassetwithpriceP
t
(P
T
=0)andcashowD
t
,
P
t
(s)=E
t

u=t +1

u
(s)

t
(s)
D
u
(s)

or,inreturnform,
E
t

t +1
(s)

t
(s)
R
t +1
(s)

=1, R
t +1
(s)=
P
t +1
(s)+D
t +1
(s)
P
t
(s)
Stochasticprocess
t
(s)isalsocalledthestate-pricedensity(SPD).
FTAPimpliestheLawofOnePrice.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 11/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AbsenceofArbitrage
FromSPDtoNoArbitrage
Proveonedirection(theeasierone):ifSPDexists,therecanbenoarbitrage.
LetW
t
denotetheportfoliovalue,(
1
,...,
N
)areholdingsofriskyassets
1,...,N.
Managetheportfoliobetweent =0andt =T.
AnarbitrageisastrategysuchthatW
0
0whileW
T
0,W
T
= 0.
Thetradingstrategyisself-nancingifitdoesnotgenerateanycashin- or
out-owsexceptfortime0andT.
Formalself-nancingcondition
W
t +1
=
t
i
+1
P
t
i
+1
=
t
i
(P
t
i
+1
+D
t
i
+1
)
i i
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 12/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

AbsenceofArbitrage
FromSPDtoNoArbitrage
Showthatself-nancingimpliesthat
t
W
t
=E
t
[
t +1
W
t +1
]:
selfnancing
E
t
[
t +1
W
t +1
] =E
t
[
t +1

t
i
+1
P
t
i
+1
] = E
t

t +1

t
i
(P
t
i
+1
+D
t
i
+1
)
i i
FTAP
=
t
i

t
P
t
i
=
t
W
t
i
Startat0anditerateforward

0
W
0
=E
0
[
1
W
1
] =E
0
[E
1
[
2
W
2
]]
=E
0
[
2
W
2
] =...
=E
0
[
T
W
T
]
GiventhattheSPDispositive,itisimpossibletohaveW
0
0whileW
T
0,
W
T
=0.Thus,therecanbenoarbitrage.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AbsenceofArbitrage
FundamentalTheoremofAssetPricing(FTAP)
Whenthereexistsafullsetofstate-contingentclaims(marketsare
complete),thereisauniqueSPDconsistentwithabsenceofarbitrage:

t
(s)isthepriceofastate-contingentclaimpaying$1instatesattimet ,
normalizedbytheprobabilityofthatstate,p
t
.
Thereverseisalsotrue:ifthereexistsonlyoneSPD,alloptionsare
redundant.
Whentherearefewerassetsthanstatesofnature,therecanbemanySPDs
consistentwithnoarbitrage.
FTAPsaysthatifthereisnoarbitrage,theremustbeatleastonewayto
introduceaconsistentsystemofpositivestateprices.
Wedropexplicitstate-dependenceandwrite
t
insteadof
t
(s).
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

Example:BinomialTree
SPD
Optionsareredundant:anypayoffcan
bereplicatedbydynamictrading.
FTAPimpliesthat
p

t +1
(u)
(1+r ) + (1p)

t +1
(d)
(1+r ) = 1
S
t +1
=uS,
t +1
(u)

t
p

t +1
(u)
t +1
(d)
p u+ (1p) d = 1
S
t
,
t

t
(1p)
SPDisuniqueuptonormalization
S
t +1
=dS,
t +1
(d)

0
=1:

t +1
(u) 1 1+rd
=

t
p(1+r ) ud

t +1
(d)
=
1 u(1+r )

t
(1p)(1+r ) ud
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 15/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Arbitrage-FreeModelsusingSPD
DiscountedCashFlowModel(DCF)
Algorithm:ADCFModel
1
Specifytheprocessforcashows,D
t
.
2
SpecifytheSPD,
t
.
3
Derivetheassetpriceprocessas
P
t
=E
t

u=t +1

t
D
u

(DCF)
Tomakethispractical,needtolearnhowtoparameterizeSPDsinstep(2),
sothatstep(3)canbeperformedefciently.
Canusediscrete-timeconditionallyGaussianprocesses.
SPDsarecloselyrelatedtorisk-neutralpricingmeasures.Usefulforbuilding
intuitionandforcomputations.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
SPDandtheRiskPremium
LetR
t +1
bethegrossreturnonariskyassetbetweent andt+1:

t +1
E
t
R
t +1
=1

t
E
t

t +1
(1+r
t
) =1

t
Usingthedenitionofcovariance,
ConditionalRiskPremiumandSPDBeta
RiskPremium
t
E
t
[R
t +1
](1+r
t
)=(1+r
t
)Cov
t

R
t +1
,

t +1

c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 18/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
SPDandCAPM
CAPMsaysthatriskpremiaonallstocksmustbeproportionaltotheirmarket
betas.
CAPMcanbere-interpretedasastatementabouttheSPDpricingallassets.
Assumethat

t +1
/
t
=abR
t
M
+1
whereR
M
isthereturnonthemarketportfolio.(Theaboveformulamaybe
viewedasapproximation,ifitimpliesnegativevaluesof).
Usingthegeneralformulafortheriskpremium,foranystockj ,
E
t
R
t
j
+1
(1+r
t
) =constCov
t
(R
t
j
+1
,R
t
M
+1
)
Theaboveformulaworksforanyasset,includingthemarketreturn.Usethis
tondtheconstant:


Cov
t
(R
t
j
+1
,R
t
M
+1
)
E
t
R
t
j
+1
(1+r
t
) =E
t
R
t
M
+1
(1+r
t
)
Var
t
(R
t
M
+1
)
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

SPDandMulti-FactorModels
Alternativetheories(e.g.,APT),implythattherearemultiplepricedfactorsin
returns,notjustthemarketfactor.
Multi-factormodelsarecommonlyusedtodescribethecross-sectionofstock
returns(e.g.,theFama-French3-factormodel).
Assumethat

t +1
/
t
=a+b
1
F
t
1
+1
+...b
K
F
t
K
+1
whereF
k
,k =1,...,K areK factors.Factorsmaybeportfolioreturns,or
non-returnvariables(e.g.,macroshocks).
Thenriskpremiaonallstockshavefactorstructure

K

E
t
R
t
j
+1
(1+r
t
) =
k
Cov
t
R
t
j
+1
,F
t
k
+1
k=1
FactormodelsaresimplystatementsaboutthefactorstructureoftheSPD.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
SPDsandRisk-NeutralPricing
OnecanbuildmodelsbyspecifyingtheSPDandcomputingallassetprices.
Itistypicallymoreconvenienttousearelatedconstruction,called
risk-neutralpricing.
Risk-neutralpricingisamathematicalconstruction.Itisoftenconvenientand
addssomethingtoourintuition.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

Risk-NeutralMeasures
TheDCFformulationwithanSPDismathematicallyequivalenttoachange
ofmeasurefromthephysicalprobabilitymeasuretotherisk-neutral
measure.Therisk-neutralformulationoffersausefulandtractablealternative
totheDCFmodel.
LetPdenotethephysicalprobabilitymeasure(theonebehindempirical
observations),andQdenotetherisk-neutralmeasure.Qisamathematical
constructionusedforpricingandonlyindirectlyconnectedtoempiricaldata.
LetB
t
denotethevalueoftherisk-freeaccount:
t 1
B
t
= (1+r
u
)
u=0
wherer
u
istherisk-freerateduringtheperiod[u,u+1).
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Risk-NeutralMeasures
Qisaprobabilitymeasureunderwhich
=E
P
T

u
=E
Q
T
B
t
P
t
t
D
u
t
D
u
, foranyassetwithcashowD

t
B
u
u=t +1 u=t +1
UnderQ,thestandardDCFformulaholds.
UnderQ,expectedreturnsonallassetsareequaltotherisk-freerate:
E
Q
[R
t +1
] =1+r
t
t
IfQhaspositivedensitywithrespecttoP,thereisnoarbitrage.
Theremayexistmultiplerisk-neutralmeasures.
Qisalsocalledanequivalentmartingalemeasure(EMM).
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
SPDandChangeofMeasure
Constructrisk-neutralprobabilitiesfromtheSPD.
Considerourtree-modelofthemarketandletC(
t
)denotethesetof
time-(t+1)nodeswhicharechildrenofnode
t
.
Denenumbersq(
t +1
)forallnodes
t +1
C(
t
)bytheformula
q(
t +1
) = (1+r
t
)q(
t
)
(
t +1
)p(
t +1
)
(
t
)p(
t
)
Recallthattheratiop(
t +1
)/p(
t
)isthenode-
t
conditionalprobabilityof

t +1
.
q(
t +1
)>0and

(
t +1
)p(
t +1
)
q(
t +1
) =q(
t
) (1+r
t
)
(
t
)p(
t
)

t +1
C(
t
)
t +1
C(
t
)
=q(
t
)E
P
t
(
t +1
)
(1+r
t
) =q(
t
)
(
t
)
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 25/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
SPDandChangeofMeasure
q(
t
)deneprobabilities.Aretheserisk-neutralprobabilities?
Foranyasseti ,
1

q(
t +1
) 1
Q
R
i
t +1
R
i
t +1
E =
t
1+r
t
q(
t
) 1+r
t

t +1
C(
t
)
(1+r
t
)
(
t +1
)p(
t +1
) 1
R
t
i
+1
=
(
t
)p(
t
) 1+r
t

t +1
C(
t
)
=

p
p
(
(
t +
t
)
1
)

(
(
t +
t
)
1
)
R
t
i
+1

t +1
C(
t
)

t +1
R
t
i
+1
=E
P
t
=1

t
Concludethatq(
t
)denerisk-neutralprobabilities.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 26/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

Example:BinomialTree
Risk-NeutralMeasure
FTAPimpliesthat
S
t +1
=uS,
t +1
(u)
q
1+rd
qu+(1q)d =1+r
t
q=
S
t
,
t

ud
Alternatively,computetransition
(1q)
probabilityunderQusingtheSPD
S
t +1
=dS,
t +1
(d)
:
q=p(1+r
t
)

t +1
(u)

t
1 1+r
t
d 1+r
t
d
=p(1+r
t
) =
p(1+r
t
) ud ud
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Normality-PreservingChangeofMeasure
Results
UnderP,
P
N(0,1).DeneanewmeasureQ,suchthatunderQ,

P
N(,1).
Let=
d
d
Q
P
.Then,
(
P
) =exp
(
P
+)
2
+
(
P
)
2
=exp
P

2
2 2 2
Thechangeofmeasureisgivenbyalog-normalrandomvariable(
P
)
servingasthedensityofthenewmeasure.
Normality-PreservingChangeofMeasure
dQ
dP
=e

2
/2

Q
=
P
+N(0,1)underQ
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
PriceofRisk
WhenPandQarebothGaussian,wecandenethepriceofrisk(keynotion
incontinuous-timemodels).
Consideranassetwithgrossreturn
R
t +1
=exp
t

t
2
/2+
t

P
t +1
, E
t
[R
t +1
] =exp(
t
)
where
P
t +1
N(0,1),IID,underthephysicalP-measure.
Lettheshort-termrisk-freeinterestratebe
exp(r
t
) 1
LettheSPDbe

t +1
=
t
exp r
t

t
2
/2
t

P
t +1
Recall

Q
=
P
+
t
t t
UnderQ,thereturndistributionbecomes
R
t +1
=exp
t

t
2
/2
t

t
+
t

Q
t +1
where
Q
t +1
N(0,1),IID,undertheQ-measure.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
PriceofRisk
UnderQ,

Q
R
t +1
=exp
t

t
2
/2
t

t
+
t

Q
t +1
,
t +1
N(0,1)
Bydenitionoftherisk-neutralprobabilitymeasure,
E
Q
t
[R
t +1
] =exp(r
t
)
t

t
=r
t

Theriskpremium(measuredusinglogexpectedgrossreturns)equals

t
r
t
=
t

t
isthequantityofrisk,

t
isthepriceofrisk.
Modelswithtime-varyingpriceofrisk,
t
,exhibitreturnpredictability.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Overview
Asanexampleofhowrisk-neutralpricingisused,weconsidertheproblemof
optionpricingwhentheunderlyingassetexhibitsstochasticvolatility.
ThebenchmarkmodelistheBlack-Scholesmodel.
Stock(underlying)volatilityintheB-Smodelisconstant.
Empirically,theB-Smodelisrejected:theimpliedvolatilityisnotthesamefor
optionswithdifferentstrikes.
TherearemanypopulargeneralizationsoftheB-Smodel.Weexplorethe
modelwithanEGARCHvolatilityprocess.
TheEGARCHmodeladdressessomeoftheempiricallimitationsoftheB-S
model.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
TheBlack-ScholesModel
ConsiderastockwithpriceS
t
,nodividends.Assumethat
S
t +1

=exp
2
/2+
P
t +1
,
S
t
where
P
t +1
N(0,1),IID,underthephysicalP-measure.
Assumethattheshort-terminterestrateisconstant.
AssumethatundertheQ-measure,
S
t +1

=exp /2+
Q
t +1
,
t +1
N(0,1), IID r
2

Q
S
t
Thetime-tpriceofanyEuropeanoptiononthestock,withapayoff
C
T
=H(S
T
),isgivenby
=E
Q
e
r (Tt )
H(S
T
) C
t
t
Thisisanarbitrage-freemodel.PricesofEuropeancallandputoptionsare
givenbytheBlack-Scholesformula.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
ImpliedVolatility
TheBlack-Scholesmodelexpressesthepriceoftheoptionasafunctionof
theparametersandthecurrentstockprice.
EuropeanCalloptionprice
C(S
t
,K,r ,,T)
Impliedvolatility
i
ofaCalloptionwithstrikeK
i
andtimetomaturityT
i
is
denedby
C
i
=C(S
t
,K
i
,r ,
i
,T
i
)
ImpliedvolatilityreconcilestheobservedoptionpricewiththeB-Sformula.
Optionpricesaretypicallyquotedintermsofimpliedvolatilities.
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Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
ImpliedVolatilitySmile(Smirk)
IfoptionpricessatisedtheB-Sassumptions,allimpliedvolatilitieswouldbe
thesame,equalto,thevolatilityoftheunderlyingpriceprocess.
Empirically,impliedvolatilitiesdependonthestrikeandtimetomaturity.
2
QUANTITATIVE STRATEGIES RESEARCH NOTES
Sac hs
Goldman
The bi nomi al tree correspondi ng to the ri sk-neutral stock evol uti on i s
the same for al l opti ons on that stock, i rrespecti ve of thei r stri ke l evel
or ti me to expi rati on. The stock tree cannot know about whi ch
opti on we are val ui ng on i t.
Market opti ons pri ces are not exactl y consi stent wi th theoreti cal
pri ces deri ved from the BS formul a. Neverthel ess, the success of the
BS framework has l ed traders to quote a cal l opti ons market pri ce i n
terms of whatever constant l ocal vol ati l i ty
imp
makes the BS for-
mul a val ue equal to the market pri ce. We cal l
imp
the Black-Scholes-
equivalent or implied volatility, to di sti ngui sh i t from the theoreti -
cal l y constant l ocal vol ati l i ty assumed by the BS theory. I n essence,

imp
i s a means of quoti ng pri ces.
How consi stent are market opti on pri ces wi th the BS formul a? Fi gure
2(a) shows the decrease of
imp
wi th the stri ke l evel of opti ons on the
S&P 500 i ndex wi th a xed expi rati on of 44 days, as observed on May
5, 1993. Thi s asymmetry i s commonl y cal l ed the vol ati l i ty skew.
Fi gure 2(b) shows the i ncrease of
imp
wi th the ti me to expi rati on of
at-the-money opti ons. Thi s vari ati on i s general l y cal l ed the vol ati l i ty
term structure. I n thi s paper we wi l l refer to them col l ecti vel y as
the vol ati l i ty smi l e.
FIGURE 2. Implied Volatilities of S&P 500 Options on May 5, 1993
I n Fi gure 2(a) the data for stri kes above (bel ow) spot comes from cal l
(put) pri ces. I n Fi gure 2(b) the average of at-the-money cal l and put
i mpl i ed vol ati l i ti es are used. You can see that
imp
fal l s as the stri ke
l evel i ncreases. Out-of-the-money puts trade at hi gher i mpl i ed vol a-
ti l i ti es than out-of-the-money cal l s. Though the exact shape and mag-
ni tude vary from day-to-day, the asymmetry persi sts and bel i es the
BS theory, whi ch assumes constant l ocal (and therefore, constant
The Smile
(a) (b)
O
O
O
O
O
O
O
O O
O
option strike (% of spot)
90 92 94 96 98 100 102 104
1
0
1
2
1
4
1
6
1
8
O
O
O
O
O
option expiration (days)
o
p
t
i
o
n

i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y

(
%
)
50 100 150 200
1
0
1
1
1
2
1
3
o
p
t
i
o
n

i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y

(
%
)
Source:E.Derman,I.Kani,1994,TheVolatilitySmileandItsImpliedTree,QuantitativeStrategiesResearchNotes,GoldmanSachs
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 35/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

EGARCHModel
ConsideramodelofstockreturnswithEGARCHvolatilityprocess.
Assumethestockpaysnodividends,andshort-terminterestrateisconstant.
Stockreturnsareconditionallylog-normallydistributedundertheQ-measure
ln
S
S
t
t
1
=r

t
2
2
1
+
t 1

Q
t
,
Q
t
N(0,1), IID
Conditionalexpectedgrossreturnontheunderlyingassetequalsexp(r ).
Conditionalvolatility
t
followsanEGARCHprocessunderQ

2
ln
t
=a
0
+b
1
ln
t 1
+
Q
t 1
+
t 1

Optionpricescanbecomputedusingtherisk-neutralvaluationformula.
c Arbitrage-FreePricingModels 36/48 LeonidKogan (MIT,Sloan) 15.450,Fall2010

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures

OptionValuationbyMonteCarlo
WeuseMonteCarlosimulationtocomputeoptionprices.
Usingthevaluationformula
=E
Q
e
r (Tt )
H(S
T
) C
t
t
CalloptionpricecanbeestimatedbysimulatingNtrajectoriesofthe
underlyingassetS
u
n
,n=1,...,N,underQ,andaveragingthediscounted
payoff
C
t

N
1
N
e
r(Tt )
max(S
T
n
K,0)
n=1
Resultingoptionpricesarearbitrage-freebecausetheysatisfythe
risk-neutralpricingrelationship.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 37/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Simulation
Useone-weektimesteps.
CalibratetheparametersusingtheestimatesinDayandLewis(1992,Table
3)
a
0
b
1

-3.620 0.529 -0.273 0.357
Calibratetheinterestrate
exp(52r ) =exp(0.05)
StartallNtrajectorieswiththesameinitialstockpriceandthesameinitial
volatility,
0
=15.5%/

52.
ComputeimpliedvolatilitiesforCall/Putoptionswithdifferentstrikes.
PlotimpliedvolatilitiesagainstBlack-ScholesdeltasofPutoptions
(
t
=P
t
/S
t
).
c Arbitrage-FreePricingModels 38/48 LeonidKogan (MIT,Sloan) 15.450,Fall2010
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
VolatilitySmile
0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6
14
14.5
15
15.5
16
16.5
|Option Delta|
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y

(
%
)


12 Weeks
24 Weeks
36 Weeks
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 39/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Futures
Wewanttobuildanarbitrage-freemodeloffuturesprices.
Incaseofdeterministicinterestratesandcostlessstorageoftheunderlying
asset,futurespriceisthesameastheforwardprice.
Inmostpracticalsituations,storageisnotcostless,sosimplereplication
argumentsarenotsufcienttoderivefuturesprices.
Wanttomodelfuturespricesformultiplematuritiesinanarbitrage-free
framework.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 41/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Risk-NeutralPricing

T
t
isthetime-t futurespriceforacontractmaturingatT.
Futuresarecontinuouslysettled,sotheholderofthelongpositioncollects

T
t t 1
eachperiod.Continuoussettlementreducesthelikelihoodofdefault.
Themarketvalueofthecontractisalwaysequaltozero.
Intherisk-neutralpricingframework
T
B
t
Q

T
u

T
u1
E =0 forallt
t
B
u
u=t +1
Weconclude(usingbackwardsinductionanditeratedexpectations)thatthe
futurespricesmustsatisfy
E
Q
t

T
t +1

T
t
=0 forallt
andthus

T
t
=E
Q

T
T
=E
Q
t
[S
T
]
t
whereS
T
isthespotpriceatT.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 42/48

Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AR(1)SpotPrice
SupposethatthespotpricefollowsanAR(1)processundertheP-measure
S
t
S=(S
t 1
S) +
P
t
,
P
t
N(0,1), IID
Assumethattherisk-neutralQ-measureisrelatedtothephysicalP-measure
bythestate-pricedensity

t +
t
1
=exp r
t

2
2

P
t +1
Marketpriceofriskisconstant.
Tocomputefuturesprices,use
Q
t
=
P
t
+.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 43/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AR(1)SpotPrice
Undertherisk-neutralmeasure,spotpricefollows

S
t
= S

+ S
t 1
S

+
Q
1 1
t
Deneanewconstant
S
Q
S

1
Then

S
t
S
Q
= S
t 1
S
Q
+
Q
t
UnderQ,spotpriceisstillAR(1),samemean-reversionrate,butdifferent
long-runmean.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 44/48




Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
AR(1)SpotPrice
Tocomputethefuturesprice,iteratetheAR(1)processforward
Q Q
Q
t +1
S
t +1
S = S
t
S +
Q Q
+
Q
t +2
S
t +2
S = S
t +1
S
=
2
S
t
S
Q
+
t +2
+
Q Q
1 t +
.
.
.
Q Q
+
Q
t +n
+...+
n2 Q

t +2
+
n1

Q
t +1
=
n
S
t +n
S S
t
S
Weconcludethat
[S
T
] =S
Q

1
Tt

T
t
=E
Q
t
+
Tt
S
t
Futurespricesofvariousmaturitiesgivenbytheabovemodeldonotadmit
arbitrage.
c Arbitrage-FreePricingModels 45/48 LeonidKogan (MIT,Sloan) 15.450,Fall2010


Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
ExpectedGainonFuturesPositions
Whatistheexpectedgainonalongpositioninafuturescontract?
UnderQ,theexpectedgainiszero:
E
Q

T
t +1

T
=0 forallt
t t
Futurescontractsprovidesexposuretorisk,
P
.Thisriskiscompensated,
withthemarketpriceofrisk.

T
t +1

T
t
=
Tt 1

Q
t +1
=
Tt 1
+
Tt 1

P
t +1
(Use
Q
t +1
=+
P
t +1
)
UnderP,expectedgainisnon-zero,because
Q
hasnon-zeromeanunderP
E
P

T
t +1

T
=
Tt 1
forallt
t t
Canestimatemodelparameters,including,fromhistoricalfuturesprices.
c Arbitrage-FreePricingModels 46/48 LeonidKogan (MIT,Sloan) 15.450,Fall2010
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Summary
ExistenceofSPDorrisk-neutralprobabilitymeasureguaranteesabsenceof
arbitrage.
Factorpricingmodels,e.g.,CAPM,aremodelsoftheSPD.
Canbuildconsistentmodelsofmultipleoptionsbyspecifyingtherisk-neutral
dynamicsoftheunderlyingasset.
Black-Scholesmodel,volatilitysmiles,andstochasticvolatilitymodels.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 47/48
Introduction ArbitrageandSPD FactorPricingModels Risk-NeutralPricing OptionPricing Futures
Readings
Back2005,Chapter1.
E.Derman,I.Kani,1994,TheVolatilitySmileandItsImpliedTree,
QuantitativeStrategiesResearchNotes,GoldmanSachs.
T.Day,C.Lewis,1992,StockMarketVolatilityandtheInformationContentof
StockIndexOptions,JournalofEconometrics52,267-287.
c LeonidKogan (MIT,Sloan) Arbitrage-FreePricingModels 15.450,Fall2010 48/48
MIT OpenCourseWare
http://ocw.mit.edu
15.450 Analytics of Finance
Fall 2010
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms .