InstitutionalFinance

Lecture 10: Dynamic

Lecture10:
DynamicArbitragetoReplicate
Arbitrage to Replicate
nonlinearPayoffs
MarkusK.Brunnermeier

p
g
Preceptor:
DongBeom
Choi
PrincetonUniversity
1

BINOMIALOPTIONPRICING
BINOMIAL OPTION PRICING

ConsideraEuropeancalloptionmaturingattimeT
withstrikeK:C
i h ik K CT=max(S
(STK,0),nocashflowsinbetween
K 0)
h fl
i b
Isthereawaytostaticallyreplicatethispayoff?

Notusingjustthestockandriskfreebond
h
k d kf
b d requiredstock
d
k
positionchangesforeachperioduntilmaturity(aswewill
see))
Needtodynamicallyhedge comparewithstatichedge
suchashedgingaforward,orhedgeusingputcallparity

Replicationstrategydependsonspecifiedrandom
processofstockprice needtoknowhowprice
evolves over time Binomial (Cox Rubinstein Ross)
evolvesovertime.Binomial(CoxRubinsteinRoss)
modeliscanonical

ASSUMPTIONS

Assumptions:

Stockwhichpaysnodividend
St k hi h
di id d
Overeachperiodoftime,stockpricemovesfromStoeither
uS ordS,i.i.d.overtime,sothatfinaldistributionofST is
binomial
uS

S
dS

Supposelengthofperiodishandrisk
Suppose
length of period is h and riskfree
freerateisgivenby
rate is given by
R=erh
Noarbitrage:u>R>d
Note: simplistic model but as we will see with enough
Note:simplisticmodel,butaswewillsee,withenough
periodsbeginstolookmorerealistic

AONE
PERIODBINOMIALTREE
A ONEPERIOD
BINOMIAL TREE

Exampleofasingleperiodmodel

S=50,u=2,d=0.5,R=1.25

100

50
25

WhatisvalueofaEuropeancalloptionwithK=50?
What
is value of a European call option with K=50?
Optionpayoff:max(STK,0)
50
C=?
0

Usereplicationtoprice

SINGLE
PERIODREPLICATION
SINGLEPERIOD
REPLICATION

ConsideralongpositionofinthestockandB
dollarsinbond
d ll i b d
Payofffromportfolio:

uS+RB=100 +1.25B

S+B=50 +B
dS+RB=25 +1.25B

DefineCu asoptionpayoffinupstateandCd asoption

payoffindownstate(Cu=50,Cd=0here)
R li i
Replicatingstrategymustmatchpayoffs:
h
ff
Cu=uS+RB
Cd=dS+RB

SINGLE
PERIODREPLICATION
SINGLEPERIOD
REPLICATION

Solvingtheseequationsyields:
Cu Cd
=
S (u d )
uCd dCu
B=
R (u d )

IInpreviousexample,=2/3andB=13.33,sothe
i
l 2/3 d B 13 33
h
optionvalueis
C = S
S+B
B = 20

Interpretationof:sensitivityofcallpricetoa
changeinthestockprice.Equivalently,tellsyouhow
g
p
q
y,
y
tohedgeriskofoption

Tohedgealongpositionincall,shortsharesofstock

RISK
NEUTRALPROBABILITIES
RISKNEUTRAL
PROBABILITIES

SubstitutingandBfromintoformulaforC,
C=

Cu Cd
uC dCu
S+ d
S (u d )
R (u d )

1 R d
uR
Cu +
=
Cd
ud
R ud

Define p = (Rd)/(ud)
Definep=(R
d)/(u d),notethat1
note that 1p
p=(u
= (uR)/(ud)
R)/(u d),so
so
C=

1
[ pCu + (1 p )Cd ]
R

Interpretationofp:probabilitythestockgoestouS in
worldwhereeveryoneisriskneutral

RISK
NEUTRALPROBABILITIES
RISKNEUTRAL
PROBABILITIES

Notethatpistheprobabilitythatwouldjustifythe
currentstockpriceSinariskneutralworld:
1
S = [q
quS + (1 q)dS ]
R
Rd
=p
q=
ud

Noarbitragerequiresu>R>dasclaimedbefore
Note:didntneedtoknowanythingaboutthe
objectiveprobabilityofstockgoingupordown(P
measure).Justneedamodelofstockpricesto
constructQmeasureandpricetheoption.

THEBINOMIALFORMULAINAGRAPH
THE BINOMIAL FORMULA IN A GRAPH

TWO
PERIODBINOMIALTREE
TWOPERIOD
BINOMIAL TREE

Concatenationofsingleperiodtrees:
u2S
uS

udS

S
dS
d2S

TWO
PERIODBINOMIALTREE
TWOPERIOD
BINOMIAL TREE

Example:S=50,u=2,d=0.5,R=1.25
200
100

50

50
25
12 5
12.5

Optionpayoff:

150
Cu

C
Cd
0

TWO
PERIODBINOMIALTREE
TWOPERIOD
BINOMIAL TREE

Topricetheoption,workbackwardsfromfinalperiod.
150

200
Cu

100
50

Weknowhowtopricethisfrombefore:
We
know how to price this from before:
R d 1.25 0.5
=
= 0.5
p=
ud
2 0.5
1
Cu = [ pCuu + (1 p )Cud ] = 60
R
Threestepprocedure:
pp

1.Computeriskneutralprobability,p
2.PlugintoformulaforCateachnodetoforprices,goingbackwards
fromthefinalnode.
3.PlugintoformulaforandBateachnodeforreplicatingstrategy,
goingbackwardsfromthefinalnode..

TWO
PERIODBINOMIALTREE
TWOPERIOD
BINOMIAL TREE

Generalformulasfortwoperiodtree:
p=(Rd)/(ud)
p=(R d)/(u d)

Cuu

Cu=[pCuu+(1-p)Cud]/R
u=(Cuu-C
Cud)/(u2S-udS)
S udS)
Bu=Cu- uS
C=[pCu+(1-p)Cd]/R
=[p2Cuu+2p(1-p)Cud+(1-p)2Cud]/R
=(Cu-Cd)/(uS-dS)
Cd=[pCud+(1-p)Cdd]/R
B=C- S
2S))
=(C
( -C ))/(udS-d
(
d

ud

Cud

dd

Bd=Cd- dS

Synthetic option requires dynamic hedging

Syntheticoptionrequiresdynamichedging

Mustchangetheportfolioasstockpricemoves

Cdd

ARBITRAGINGAMISPRICEDOPTION
ARBITRAGING A MISPRICED OPTION

Considera3periodtreewithS=80,K=80,
u=1.5,d=0.5,R=1.1
Implies p =(R
Impliesp
(Rd)/(ud)
d)/(u d)=0.6
0.6
Candynamicallyreplicatethisoptionusing3
period binomial tree Cost is $34 08
periodbinomialtree.Costis$34.08
Ifthecallissellingfor$36,howtoarbitrage?

Selltherealcall
ll h
l ll
Buythesyntheticcall

Whatdoyougetupfront?

CS+B=36 34.08=1.92

ARBITRAGINGAMISPRICEDOPTION
ARBITRAGING A MISPRICED OPTION

Supposethatoneperiodgoesby(2periodsfrom
expiration),andnowS=120.Ifyoucloseyourposition,
whatdoyougetinthefollowingscenarios?

Callpriceequalstheoreticalvalue,$60.50.
C
ll i
l h
i l l $60 0
Callpriceislessthan60.50
Call price is more than 60 50
Callpriceismorethan60.50

Answer:

Closingthepositionyieldszeroifcallequalstheoretical
Closing
the position yields zero if call equals theoretical
Ifcallpriceislessthan60.50,closingpositionyieldsmore
thanzerosinceitischeapertobuybackcall.
Ifcallpriceismorethan60.50,closingoutpositionyieldsa
loss!Whatdoyoudo?(Rebalanceandwait.)

TOWARDSBLACK
SCHOLES
TOWARDS BLACKSCHOLES

BlackScholes canbeviewedasthelimitofabinomial
treewherethenumberofperiodsn goestoinfinity
Takeparameters:

u = e

, d = 1 / u = e

T /n

Where:

T /n

n=numberofperiodsintree
T=timetoexpiration(e.g.,measuredinyears)
=standarddeviationofcontinuouslycompoundedreturn

Alsotake

R = e rT / n

TOWARDSBLACK
SCHOLES
TOWARDS BLACKSCHOLES

GeneralbinomialformulaforaEuropeancallonnondividend
payingstocknperiodsfromexpiration:

1n
n!
j
n j
j n j
C =
p (1 p ) max(0, u d S K )
R j =0 j! ( n j )!

Substitute u d and R and letting n be very large (hand waving

Substituteu,d,andRandlettingnbeverylarge(handwaving
here),getBlackScholes:

C = SN (d1 ) Ke rT N (d 2 )
d1 =

[ln(S / K ) + (r +

T
d 2 = d1 T

/ 2 )T

INTERPRETINGBLACK
SCHOLES
INTERPRETING BLACKSCHOLES

NotethatinterpretthetradingstrategyundertheBSformulaas

call = N (d1 )

Bcallll = Ke rT N (d 2 )

Priceofaputoption:useputcallparityfornondividendpaying
stock
P = C S + Ke rT

= Ke rT N ( d 2 ) SN ( d1 )

Reminderofparameters

5parameters
S =currentstockprice,K =strike,T =timetomaturity,r =annualized
continuouslycompoundedriskfreerate,=annualizedstandarddev.of
cont.compoundedrateofreturnonunderlying

INTERPRETINGBLACK
SCHOLES
INTERPRETING BLACKSCHOLES
Optionhasintrinsicvalue [max(SK,0)]andtimevalue
[Cmax(SK,0)]
50
45
40
35
30
25
Time Value

20

Intrinsic Value

15
10
5
0
0.001
3
6
9
12
15
18
21
24
27
30
33
36
39
42
45
48
51
54
57
60
63
66
69
72
75
78

DELTA

Recallthatisthesensitivityofoptionpricetoasmallchangein
thestockprice

Numberofsharesneededtomakeasyntheticcall
Also measures riskiness of an option position
Alsomeasuresriskinessofanoptionposition

Fromtheformulaforacall,

call = N (d1 )

Bcall = Ke rT N (d 2 )

Acallalwayshasdeltabetween0and1.
Similarexercise:deltaofaputisbetween1and0.
D l
Deltaofastock:1.Deltaofabond:0.
f
k 1 D l
f b d 0
Deltaofaportfolio: portfolio = N i i

DELTA HEDGING
DELTAHEDGING

Aportfolioisdeltaneutral if

portfolio = N i i = 0

Deltaneutralportfoliosareofinterestbecausetheyareawayto
hedgeouttheriskofanoption(orportfolioofoptions)
Example: suppose you write 1 European call whose delta is 0 61
Example:supposeyouwrite1Europeancallwhosedeltais0.61.
Howcanyoutradetobedeltaneutral?

nc callll + ns S = 1(0.61) + ns (1) = 0

Soweneedtohold0.61sharesofthestock.
Deltahedgingmakesyoudirectionallyneutral ontheposition.

FINALNOTESONBLACK
SCHOLES
FINAL NOTES ON BLACKSCHOLES

Deltahedgingisnotaperfecthedgeifyoudonottrade
continuously

DeltaGammahedgingreducesthebasisriskofthehedge.
BS model assumes that volatility is constant over time This is a
BSmodelassumesthatvolatilityisconstantovertime.Thisisa
badassumption

Deltahedgingisalinearapproximationtotheoptionvalue
Butconvexityimpliessecondorderderivativesmatter
Hedgeismoreeffectiveforsmallerpricechanges

Volatilitysmile
BS underprices outofthemoneyputs(andthusinthemoneycalls)
BSunderprices
out of the money puts (and thus in the money calls)
BSoverpricesoutofthemoneycalls(andthusinthemoneyputs)
Waysforward:stochasticvolatility

Otherissues:stochasticinterestrates,bidasktransaction
h
bd k

costs,etc.

COLLATERALDEBTOBLIGATIONS(CDO)
COLLATERAL DEBT OBLIGATIONS (CDO)

CollateralizedDebtObligation
g
repackagecash
p
g
flowsfromasetofassets
Tranches:Seniortrancheispaidoutfirst,
p
,
Mezzaninesecond,juniortrancheispaidoutlast
Canadaptoptionpricingtheory,usefulinpricing
p p
p
g
y,
p
g
CDOs:

Tranchescanbepricedusinganaloguesfromoption
pricingformulas
Estimateimplieddefaultcorrelationsthatpricethe
tranches correctl
tranchescorrectly