# Introduction History Revolution Aftermath

**Financial derivatives - a brief introduction
**

Tony Ware

MITACS 6th Annual Conference, May 11 2005

Tony Ware

Financial derivatives - a brief introduction

Introduction History Revolution Aftermath

Outline

Introduction History Revolution is in the air A lot has happened since then

Tony Ware

Financial derivatives - a brief introduction

Introduction History Revolution Aftermath

Markets and risk Options

Outline

Introduction Markets and risk Options History Revolution is in the air A lot has happened since then

Tony Ware

Financial derivatives - a brief introduction

Introduction History Revolution Aftermath

Markets and risk Options

**The Midas formula V = SN(d+ ) − K e−rT N(d− )
**

It appears to be a simple, harmless formula—for the value of a call option, a simple derivative—but it has been responsible for the making—and the losing—of unimaginable riches. It is a mathematical formula, and the ideas behind it are subtle. How is it that beautiful mathematics managed to get mixed up in the business of making money? And why aren’t mathematicians doing better out of it?

Tony Ware

Financial derivatives - a brief introduction

Introduction History Revolution Aftermath

Markets and risk Options

Aristotle: 384-322 B.C.

The discussion of [wealth-getting] is not unworthy of philosophy, but to be engaged in [it] practically is illiberal and irksome.

Thales’ call option: he pays a small deposit up front guaranteeing him the ﬁrst call on a wine press (at an agreed rent). If the harvest is bad, he won’t bother to exercise his option. But if the harvest is good, he does, makes a lot of money, and has his story told by Aristotle.

Tony Ware

Financial derivatives - a brief introduction

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But what about the successes of traders who seem to have enough skill to pick the right stocks and beat the market?
Tony Ware Financial derivatives .Introduction History Revolution Aftermath
Markets and risk Options
Chance and skill
Aristotle thought that in the making of wealth too much was down to chance and not enough to human skill.a brief introduction
.

a brief introduction
.Introduction History Revolution Aftermath
Markets and risk Options
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Markets are risky!
Tony Ware
Financial derivatives .

a brief introduction
.Introduction History Revolution Aftermath
Markets and risk Options
Tony Ware
Financial derivatives .

you have the right to sell it for $50. For example: suppose that the stock is currently at $50 and you protext yourself by purchasing a put option with strike price $50. you can sell it for $60. .Introduction History Revolution Aftermath
Markets and risk Options
Risk protection: selling
Suppose you hold a stock and want to sell it in a year’s time. A put option allows you to ‘lock-in’ a minimum price for your stock. But if it has fallen to $40.a brief introduction
. but to keep the unlimited upside. When the contract expires. if the stock has risen to $60.
Tony Ware
Financial derivatives . .

. you have the right to buy it for $50. . if the stock has risen to $60.a brief introduction
. When the contract expires. the you will buy it for $50 . perhaps you want to invest in the stock.Introduction History Revolution Aftermath
Markets and risk Options
Risk protection: buying
On the other hand. For example: suppose that the stock is currently at $50 and you protext yourself by purchasing a call option with strike price $50. But if it has fallen to $40. A call option allows you to guarantee a maximum price you will have to pay.
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Markets and risk Options
Payoﬀ diagram for a call option
Tony Ware
Financial derivatives .a brief introduction
.

Introduction History Revolution Aftermath
Markets and risk Options
Leverage
Some people trade in options because want to reduce their exposure to risk.a brief introduction
. the payoﬀ is $10 and the proﬁt is $8. because they want to take on extra risk and gain an advantage from the increased leverage.
If the stock goes up. A 100% loss!
Tony Ware Financial derivatives . Others. the payoﬀ is zero and we get nothing. Here is our example call option struck at $50:
Suppose the premium for the option is $2. A 400% gain! If the stock goes down.

calls.Introduction History Revolution Aftermath
Markets and risk Options
Risk transfer
Financial derivatives come in many varieties
puts. The key question we are always trying to answer is: How much is that uncertainty worth?
Tony Ware
Financial derivatives . swing options. swaptions. up-and-out/down-and-out options. butterﬂy spreads. bull/bear spreads.a brief introduction
. condors. american/european/asian/bermudan options. futures. . passport options. .
They all involve the exchange of risk (or uncertainty). digital options.

Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Outline
Introduction History Options trading Bachelier Gaining understanding Revolution is in the air A lot has happened since then
Tony Ware
Financial derivatives .a brief introduction
.

Chigaco.Chigaco. Investment act legitimises options.Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
A long. April 1973 .Holland. 000 contracts by 1968.disreputable history
1600s .000 contracts. many speculators fail to honour their commitments.
1700s . 1974 . But the market crashes.Mathematics!
Tony Ware Financial derivatives . So what happened to cause this explosive growth? .000 to over 200.USA. The daily volume grows from 20. and the Dutch economy is brought to its knees. and growers and dealers are trading in options to guarantee prices. Annual volume < 300. The CBOT starts trading listed call options on 16 stocks.a brief introduction
. Options are declared illegal! 1934 . with a ﬁrst-day volume of 911 contracts.
Soon speculators are joining in and a thriving options market is born.London. Tulip dealing is big business.

has its beginning in the 1900 e doctoral thesis of Louis Bachelier on the ‘Th´orie de la Sp´culation’. e He studies the movements of bond prices and associated options on the Parisian Bourse.Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
The mathematicians are coming
The search for a mathematical understanding of the behaviour of the market.ﬁve years before Einstein’s work on the subject. His price model is an example of Brownian motion .
Tony Ware
Financial derivatives .his career falters and his work lies waiting until it is rediscovered more than ﬁfty years later. and options pricing.a brief introduction
. He derives an analogy between the probability distribution of prices and the ﬂow of heat. But his thesis is hardly noticed at the time .

Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Brownian motion
In 1827 Robert Brown had observed pollen particles ﬂoating in water under the microscope and noted their jittery behaviour. but continuous curves. Any non-overlapping changes are independent.) Between any two points in time (t and t + ∆t).
Tony Ware Financial derivatives . the curve is peaked. inﬁnitely-long.a brief introduction
. Bachelier models bond price movements in the same way Einstein later models the motion of particles under ‘bombardment’. For times that are close together. the change in the bond price is a normally-distributed random variable—following a ‘bell-curve’ law. In order to make sure that the motion was not due to the pollen being alive he did the same thing with dust particles. and for longer times it is smeared out.(In fact he derives his results in three diﬀerent ways. This produces random.

a brief introduction
.Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Brownian motion in pictures
Tony Ware
Financial derivatives .

this prevents the model from generating negative stock prices. In 1955 Paul Samuelson turns his attention to option pricing. Kiyoshi Itˆ. They also redeﬁne Bachelier’s model so that it refers to the logarithm of the stock price .
Tony Ware
Financial derivatives . N. Kolmogorov. and Itˆ ﬁgures out how to do calculus on these random functions. Brownian motions are now called Wiener processes by the mathematicians. Paul o L´vy and Norbert Wiener put the mathematical description of e o Brownian motion on a much ﬁrmer basis. He and his students discover Bachelier’s thesis.Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Rediscovery and enhancement
In the 1930s and 40s.a brief introduction
. A.

a brief introduction
.Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Geometric Brownian motion
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
The hunt is on
In the period 1955-1970. a paper with o Samuelson.ﬁgures out ‘boundary conditions’ Case Sprenkle . Henry McKean . creates an option model based on a discounted expected payoﬀ. James Boness . He ﬁgures out the mathematical formulae.
Tony Ware
Financial derivatives .almost gets there.translated Bachelier’s thesis. Perhaps they had an inkling of how important such a discovery might be. people were working very hard indeed to try to solve the option pricing problem. Ed Thorp . Guynemer Giguere .a brief introduction
.his model requires estimates of growth rates and investors risk-aversion.he’s even closer. building on Boness. Paul Samuelson .writes a book with Itˆ.

Introduction History Revolution Aftermath
Options trading Bachelier Gaining understanding
Almost there
Play Pause Resume Stop
Tony Ware
Financial derivatives .a brief introduction
.

Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Outline
Introduction History Revolution is in the air Convergence Balance The formula Publication Nobel prizes A lot has happened since then
Tony Ware
Financial derivatives .a brief introduction
.

They work on the idea of creating a small portfolio.it is what is at the root of all the problems others are having.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Convergence
In the late 1965 Fischer Black makes the journey from physics to ﬁnance. joining the consulting ﬁrm Arthur D. and meets Black. Black and Scholes work on the option pricing problem. Myron Scholes joins the faculty at MIT. Little. They realise that risk is the key . consisting of just three items:
S—the stock. and it is what options are all about.a brief introduction
. V —the option. A couple of years later.
Tony Ware
Financial derivatives . B—a risk-free bond (a costless bank account).

B and V ) so that the risk goes away. if its value is going to be anything but zero. S and V have all changed.e. If the worth of the option is independent of individual preferences.
Tony Ware Financial derivatives . the values of B.a brief introduction
. . you have found a money-making machine. (Zero net investment. then it just might be possible. or when you next come to trade. . . then you would know for sure the value of your portfolio ‘tomorrow’. could you get rid of it altogether? If you could. Your portfolio could be worth anything. Given that you invested nothing in it today.
Their idea is to try to balance this porfolio (S. . . a negative B) and investing it in S and V in some ratio. Start out by borrowing some money (i.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Make it go away. Here’s what you can do. if you choose your initial balance to minimise the uncertainty (the risk). . But. .) Tomorrow.

The gap closes. The result is that these arbitrage opportunities do not exist. everybody wants a piece. Black and Scholes adopted the standard assumptions: that the grapevine works perfectly and instantaneously that there are no barriers to anyone entering into a trade. The problem is that once word gets around. This is going to give you a handle on how the value of your option is changing with time. and your machine does not work any more.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Easy street?
Your money-making machine is what is known as an arbitrage opportunity. But this means that your perfectly-balanced portfolio must still be worth nothing tomorrow. no matter how small or how often.
Tony Ware Financial derivatives . and the eﬀect of this is to push prices the other way.a brief introduction
.

If the stock goes up.$30 = 0. Create a portfolio consisting of buying one stock.2×$15 . The value at the start must be zero .Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Perfect balance
Consider a simpliﬁed model with these ingredients: a stock. a zero interest rate. If the stock goes down. the net value is $60 . and borrowing $30.so V = $10.a brief introduction
. selling two options. a call option with strike price $45. which is currently at $50 and can move up to $60 or down to $30.$30 = 0. the net value is $30 .
Tony Ware Financial derivatives .

the answer is ‘no’.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
In continuous time
In the previous example. . . Here’s the best you can do if you rebalance once a day.a brief introduction
. Can we do this with a more realistic model? Well. we created a portfolio that was perfectly balanced .in all eventualities its value stayed at zero.
Tony Ware
Financial derivatives .

a brief introduction
.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Trading more often
If turns out that you can do better if you rebalance once an hour. .a brief introduction
. .
Tony Ware
Financial derivatives .

a brief introduction
.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Robert Merton
Merton arrived on the scene in 1968 and brought with him expertise in Itˆ calculus. Here’s the result of our previous experiment. .
Tony Ware
Financial derivatives . rebalancing every minute of the year.a brief introduction
. and an understanding of continuous-time o ‘stochastic processes’. He met Scholes in 1969 and it was he who ﬁgured out that their dream of perfect balance could be achieved by continuously adjusting their portfolio. .

a brief introduction
.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Tony Ware
Financial derivatives .

a brief introduction
. then ∂V σ2 ∂ 2V ∂V + rS + S 2 2 = rV . ∂t ∂S 2 ∂S This is what has become known as the Black-Scholes equation. If r is the continuously-compounded rate of interest earned by B. and σ is a measure of the volatility of S.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
The balance equation
Achieving perfect balance tells you that the value of your portfolio is stable over time. and the solution is the formula everyone had been looking for. and the no arbitrage principle then forces the option value to depend on S and B and the time t in a particular way. It had already been solved by McKean.
Tony Ware
Financial derivatives .

d± = ln
S K e−rT √
±
σ2 T 2
σ T
. This is known as the delta.
and r is the risk-free interest rate. or hedge ratio. where N(x) is the cumulative normal distribution function.
Tony Ware
Financial derivatives . expiring at time T . The balance is struck by selling N(d+ ) units of the asset for every unit option bought. continuously-compounded. and σ is the volatility of the asset.a brief introduction
. with strike price K is V = SN(d+ ) − K e−rT N(d− ).Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
The formula
The value of a call option on an asset S.

a brief introduction
.Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
The option value surface
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Getting it out
Black and Scholes had a little trouble getting their paper published.
Tony Ware
Financial derivatives .) Merton had written his own version. They had to try three times—the ﬁrst two times the paper was rejected without even being reviewed! (The suspicion is that Black’s non-academic position may have had something to do with it. more general than Black and Scholes’.a brief introduction
. but he graciously delayed the publication of his until their paper appeared.

Merton
Tony Ware
Financial derivatives .Introduction History Revolution Aftermath
Convergence Balance The formula Publication Nobel prizes
Nobel’s for almost all
Myron Scholes Robert C.a brief introduction
.

Introduction History Revolution Aftermath
Value Generalizations LTCM
Outline
Introduction History Revolution is in the air A lot has happened since then Calculating the value Generalizations of Black-Scholes LTCM
Tony Ware
Financial derivatives .a brief introduction
.

If the stock goes down.$30 = 0. the net value is $60 . If the stock goes up.2×$15 . the net value is $30 . selling two options.
2 Notice that the option value ($10) is 3 × $15 + 1 × $0. a call option with strike price $45.so V = $10.Introduction History Revolution Aftermath
Value Generalizations LTCM
Martingale pricing methods
Consider again our simpliﬁed model: a stock.$30 = 0.a brief introduction
. 3 2 1 If we think of 3 and 3 as the probability of the price going up
Tony Ware Financial derivatives . and borrowing $30. Create a portfolio consisting of buying one stock. which is currently at $50 and can move up to $60 or down to $30. The value at the start must be zero . a zero interest rate.

the option value is computed as a discounted expectation. This may involve numerical integration of some form or other.
Tony Ware
Financial derivatives .Introduction History Revolution Aftermath
Value Generalizations LTCM
Martingale pricing methods
Martingale pricing methods involve ﬁnding an equivalent martingale (probability) measure. Problems:
there may not be a unique EMM. the computation of the discounted expectation may not be trivial. Once this is determined.a brief introduction
.

Introduction History Revolution Aftermath
Value Generalizations LTCM
Binomial trees
If we repeat our simple model recursively. we can construct a binomial tree.
Tony Ware
Financial derivatives .a brief introduction
.

If Vjm is the option price after n steps of which j are up steps. u−d
Here r is the risk-free interest rate. then
m+1 Vjm = e−r ∆t pVj+1 + (1 − p)Vjm+1 .Introduction History Revolution Aftermath
Value Generalizations LTCM
Binomial trees
Each branch on the tree corresponds to a change from an asset price S to either uS (up step) or dS (down step) over a time interval ∆t. The computation starts from the payoﬀ at the ﬁnal time and works backwards.
with p =
er ∆t − d .
Tony Ware
Financial derivatives .a brief introduction
.

a brief introduction
.Introduction History Revolution Aftermath
Value Generalizations LTCM
Binomial tree computation of an american option
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Value Generalizations LTCM
Solving the PDE
The Black-Schole PDE ∂V ∂V σ2 ∂ 2V + rS + S 2 2 = rV ∂t ∂S 2 ∂S is a reverse-time parabolic equation that can be solved by reducing it to the heat equation. Wavelet-based methods.a brief introduction
. Explicit solutions may not exist in more general settings numerical solution methods will be needed. Fourier methods.
Finite diﬀerence/ﬁnite element methods.
Tony Ware
Financial derivatives .

Introduction History Revolution Aftermath
Value Generalizations LTCM
Solving the PDE
Tony Ware
Financial derivatives .a brief introduction
.

Introduction History Revolution Aftermath
Value Generalizations LTCM
Solving the PDE
Tony Ware
Financial derivatives .a brief introduction
.

Indiﬀerence pricing. variance-gamma. jump-diﬀusion.
Tony Ware
Financial derivatives . mean-reversion. Transaction costs and other imperfections. Exotics:
structured contracts (energy markets).
Credit derivatives.Introduction History Revolution Aftermath
Value Generalizations LTCM
Broadening the scope
Better price process models:
stochastic volatility.a brief introduction
. real options.

k. on the promise of using dynamic hedging (a. continuous rebalancing) on a huge scale to form a ‘gigantic vacuum cleaner sucking up nickels from around the world. 43% and 41% to their investors in the ﬁrst three years. They teamed up with some of the top investors from Wall Street to form a new company .Long Term Capital Management.a. They raised $3 billion from investors.a brief introduction
.Introduction History Revolution Aftermath
Value Generalizations LTCM
Death of a dream
Merton and Scholes wanted to see their ideas in practice.’ They were enormously successful .
Tony Ware
Financial derivatives . including many of the major banks.returning 20%.

to the tune of $3 billion.
Tony Ware
Financial derivatives .Introduction History Revolution Aftermath
Value Generalizations LTCM
Death of a dream
But at the tail end of the century things started to go wrong. convinced that things would stabilize. LTCM carried on as normal. The trouble started in asia . In order to prevent the global economic collapse that would have resulted from the failure of LTCM.a brief introduction
. the game was up.markets were collapsing and deviating signiﬁcantly from their historical norms. the Federal Reserve had no choice but to bail them out . When Russia defaulted.

a brief introduction
. Mathematics provides powerful tools for understanding and even controlling the nature and eﬀects of uncertainty and risk. But some humility is called for!
Tony Ware
Financial derivatives .Introduction History Revolution Aftermath
Value Generalizations LTCM
Summing up
Mathematics plays an unexpectedly signiﬁcant role in the operation of ﬁnancial markets.

ucalgary.ca/papers/MitacsShortCourse2005.pdf
Tony Ware
Financial derivatives .a brief introduction
.Introduction History Revolution Aftermath
Value Generalizations LTCM
A video-less version of these slides is available at finance.math.