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• Stock pays dividend D at time
1
t
( ) ) 1 ( , ,
) (
,
1 1
1
t T r rt
t D
e K D K S CallOnPut Ke S ll AmericanCa
− − −
− − + − ·
where
) 1 (
) (
1
t T r
e K D x
− −
− − ·
Gap Option
o Gap options are options where the option payoff jumps at the price where the
option comes into the money. PutCall Parity Holds.
o The gap call pays
1
K S − when
2
K S > .
1
K is the strike price (the price the
option holder pays at expiration to acquire the stock) and
2
K is the payment
trigger (the price at which payment on the option is triggered).
( ) ) ( ) ( , , , , , ,
2 1 1 2 1
d N e K d N Se T r K K S C
rT T − −
− ·
δ
δ σ
( ) ) ( ) ( , , , , , ,
2 1 1 2 1
d N e K d N Se T r K K S P
rT T
− + − − ·
− −δ
δ σ
T
T
e K
Se
d
rT
T
σ
σ
δ
2
2
1
2
1
ln +
,
_
¸
¸
·
−
−
T d d σ − ·
1 2
Gap Option continued…
Above: A gap option must be exercised when
1
K S > for a call or
1
K S < for a put.
Since the owner can lose money at exercise, the term “option” is a bit of a misnomer.
This possible negative payoff is reflected in a lower option price.
Exchange Option
An exchange option, also called an outperformance option, pays off only if the
underlying asset outperforms some other asset, called the benchmark.
Exchange calls maturing T in periods provide the right to obtain one unit of “risky asset
1” in exchange for one unit of “risky asset 2”.
t
S = Price of risky asset 1 at time t
t
K = Price of risky asset 2 at time t
S
δ and
K
δ are the dividend yields of the assets.
S
σ and
K
σ are the volatilities of the assets.
ρ
is the correlation between the continuously compounded returns on the two assets.
The payoff of the option is [ ]
t T
K S − , 0 max .
Exchange Option Pricing
( ) ) ( ) ( , , , , ,
2 1
d N e K d N Se T r K S C
T T
K S
δ δ
δ σ
− −
− ·
( ) ) ( ) ( , , , , ,
2 1
d N e K d N Se T r K S P
T T
K S
− + − − ·
− − δ δ
δ σ
T
T
Ke
Se
d
T
T
K
S
σ
σ
δ
δ
2
1
2
1
ln +
,
_
¸
¸
·
−
−
T d d σ − ·
1 2
K S K S
σ ρσ σ σ σ 2
2 2
− + ·
The volatility, σ, is the volatility of
,
_
¸
¸
K
S
ln over the life of the option.
Brownian Motion and Itô’s Lemma
Stochastic Differential Equations
(Will reference as equation 20.1)
) (
) (
) (
t dZ dt
t S
t dS
σ α + ·
where
o S(t) is the stock price.
o dS(t) is the instantaneous change in the stock price.
o α is the continuously compounded return on the stock.
o σ is the continuously compounded volatility.
o Z(t) is a normally distributed random variable that follows a process called
Brownian Motion.
o A stock obeying 20.1 follows a process called Geometric Brownian Motion.
Sharp Ratio
The Sharp Ratio for any asset is the ratio of the risk premium to volatility.
Sharp Ratio for Call =
σ
α r −
Sharp Ratio for Put =
σ
α ) ( r − −
for
) (
) (
) (
t dZ dt
t S
t dS
σ α + ·
Implications of Equation 20.1
1. If the stock price follows 20.1, the distribution S(T), given the current price
S(0), is lognormal, i.e.
( ) ( )
1
]
1
¸
− + Ν T T S T S
2 2
, )
2
1
( ) 0 ( ln ~ ) ( ln σ σ α
The assumption that the stock price follows geometric Brownian motion thus
provides a foundation for our assumption that the stock price is lognormally
distributed.
2. Geometric Brownian Motion allows us to describe the path of the stock price.
This is essential for barrier options which require us to compute the probability
that the price will hit the barrier.
Arithmetic Brownian Motion
Given
) ( ) ( t dZ dt t dX σ α + ·
Then ) (t X is normally distributed with
mean
t α ·
variance
t
2
σ ·
Probability [Stock Price is Less than ) (t X given ) 0 ( X ] =
1
]
1
¸
− −
t
t X t X
N
σ
α ) 0 ( ) (
Geometric Brownian Motion
Given
) ( ) (
) (
) (
t dZ dt
t S
t dS
σ δ α + − ·
Then
1
]
1
¸
0
ln
S
S
t
is normally distributed
with mean t )
2
1
(
2
σ δ α − − · variance
t
2
σ ·
Probability (Stock Price is Less than
t
S given
0
S ) =
1
1
1
1
1
]
1
¸
,
_
¸
¸
− − −
,
_
¸
¸
t
t
S
S
N
t
σ
σ δ α
2
0
2
1
ln
Definition of Brownian Motion
• A stochastic process is a random process that is a function of time.
• Brownian motion is a stochastic process that is a random walk occurring in
continuous time, with movements that are continuous rather than discrete.
o To generate Brownian motion, we would flip a coin infinitely fast and
take infinitesimally small steps at each point.
• Let Z(t) represent the value of a Brownian motion at time t. Brownian motion is
a continuous stochastic process, Z(t), with the following characteristics:
o Z(0) = 0
o Z(t+s) – Z(t) is normally distributed with mean 0 and variance s.
o Z(t+s
1
) – Z(t) is independent of Z(t) – Z(t s
2
), where s
1
, s
2
> 0.
This means that nonoverlapping increments are
independently distributed.
o Z(t) is continuous.
• Z(t) is a martingale: a stochastic process for which
[ ] ) ( ) ( ) ( t Z t Z s t Z E · +
.
• The process Z(t) is also called a diffusion process, it is continuous yet
uncertainty increases overtime.
Itô’s Lemma
Given S(t) follows a Geometric Brownian Motion,
) ( ) ( t SdZ Sdt dS σ δ α + − ·
.
Given a process C, that is a function of S and t, the dC follows Geometric Brownian
Motion defined as follows:
dt C dS C dS C dC
t SS S
+ + ·
2
2
1
Which is VERY similar to a DeltaGammaTheta approximation:
h C C
t t t h t
θ ε ε + Γ + ∆ · −
+
2
2
1
Multiplication Rules
( ) dt dZ ·
2
( ) 0
2
· dt 0 * · dZ dt
dt dZ dZ ρ · ' *
OrnsteinUhlenbeck Mean Reversion
) ( )] ( [ ) ( t dZ dt t X t dX σ α λ + − ·
Binomial Tree Models for Interest Rates
Spot Rates: interest rates available immediately.
Forward Rates: interest rates agreed upon now in an agreement to purchase a bond at
some future date.
( ) · + s T T P
t
, Price of Zero Coupon Bond
T = Time of Payment
t = Time of Agreement
T+ s = Time of Maturity
If t=T then this is a Spot Price. If t<T then this is a Forward Price as described below.
( ) · + ] , [
,
s T T P F
t T t
Forward Price for Agreement to Purchase Bond
( )
) , (
) , (
] , [
,
T t P
s T t P
s T T P F
t T t
+
· +
Interest Rates for ZeroCoupon Bonds within the Binomial Tree Model
· ) ; , (
2 1
j t t r OneYear Continuously Compounded Interest Rate
·
1
t Time of Issue
·
2
t Time of Maturity
j = node counter (begin with 0 at lowest node)
BlackDermanToy Binomial Model
BDT Assumptions and Variable Definitions
• Uses Effective Annual Yields, R, not continuously compounded yields, r.
• Bond Price = ( )
n
R
−
+ 1 where n = years to maturity
• Volatilities are the volatilities of yields on zero coupon bonds after one year.
( )
( )
h
t
e
j t t r
j t t r
1
2
2 1
2 1
; ,
1 ; ,
σ
·
+ ( )
( )
( )
( ) 1 ; ,
2 ; ,
; ,
1 ; ,
2 1
2 1
2 1
2 1
+
+
·
+
j t t r
j t t r
j t t r
j t t r
1
t = Column
1
t
h = Time Interval
t
σ
= Volatility of 1Period Yields in Period i. This is the volatility from the BDT tree.
T
σˆ = The volatility of a T year bond after one year. This is the volatility from the table.
1 2
ˆ σ σ ·
BDT Bond Price and Yield Volatility
[ ] · ) ( , , h r T h P Price of Zero Coupon Bond
h = Time of Valuation
T = Time of Maturity
r(h) = short term interest rate
Yield of this Bond =
[ ] · ) ( , , h r T h y
[ ] 1 ) ( , ,
1
−
1
]
1
¸
−
−
h T h r T h P
Then at time h the short term rate can take on the two values
u
r or
d
r .
Yield Volatility =
T
σˆ =
[ ]
[ ]
1
]
1
¸
d
u
r T h y
r T h y
, ,
, ,
ln
2
1
Implied Forward Rates
1Period forward rate in K years =
1
1
1
1
1 ,
−
+
+
·
+
+
K
K
K K
y
y
F
Caplets and Caps
The value of the cap is the value of the sum of the caplets.
The value of the year n caplet is the only the value from that year, brought back using
riskneutral probability and BDT interest rates.
Pricing Forward Rate Agreements (FRA)
• FRA pays
) , ( T t R

A
R
at time T or
[ ]
t T
A
T t R
R T t R
−
+
−
) , ( 1
) , (
at time t.
•
) , ( T t R
is the prevailing interest rate for a loan taken at time t and paid at time
T.
•
A
R
is calculated so that the expected value of the agreement is 0.
•
1
) , 0 (
) , 0 (
− ·
T P
t P
R
A
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