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dU = = Z dY + Y dZ + dY dZ ZY (a dt + b dWY ) + Y Z (f dt + g dWZ ) +Y Z (a dt + b dWY )(f dt + g dWZ ) = U (a + f + bg) dt + U b dWY + U g dWZ .

Page 514

The product of two (or more) correlated geometric Brownian motion processes thus remains geometric Brownian motion. Note that Y Z U = exp a b /2 dt + b dWY , [( ) ] 2 = exp f g /2 dt + g dWZ , [( ( 2 ) ) ] 2 = exp a + f b + g /2 dt + b dWY + g dWZ .

2

[(

Page 515

ln U is Brownian motion with a mean equal to the sum of the means of ln Y and ln Z . This holds even if Y and Z are correlated. Finally, ln Y and ln Z have correlation .

Page 516

Suppose Y and Z are drawn from p. 514. Let U Y /Z . We now show thata dU = (a f + g 2 bg) dt + b dWY g dWZ . U

(57)

a Exercise

Page 517

The multidimensional Itos lemma (Theorem 20 on p. 510) can be employed to show that

dU = = (1/Z ) dY (Y /Z 2 ) dZ (1/Z 2 ) dY dZ + (Y /Z 3 ) (dZ )2 (1/Z )(aY dt + bY dWY ) (Y /Z 2 )(f Z dt + gZ dWZ ) (1/Z 2 )(bgY Z dt) + (Y /Z 3 )(g 2 Z 2 dt) = U (a dt + b dWY ) U (f dt + g dWZ ) U (bg dt) + U (g 2 dt) = U (a f + g 2 bg) dt + U b dWY U g dWZ .

Page 518

Forward Price

Suppose S follows dS = dt + dW. S Consider F (S, t) Sey(T t) . Observe that F S 2F S 2 F t = ey(T t) , = 0, = ySey(T t) .

Page 519

Then dF = ey(T t) dS ySey(T t) dt = Sey(T t) ( dt + dW ) ySey(T t) dt = F ( y ) dt + F dW by Eq. (55) on p. 509. Thus F follows dF = ( y ) dt + dW. F This result has applications in forward and futures contracts.a

a It

Page 520

Ornstein-Uhlenbeck Process

The Ornstein-Uhlenbeck process: dX = X dt + dW, where , 0. It is known that

E [ X (t) ] Var[ X (t) ] Cov[ X (s), X (t) ] = = = e

(tt0 )

E [ x0 ] ,

(t+s2t0 )

Var[ x0 ],

Page 521

X (t) is normally distributed if x0 is a constant or normally distributed. X is said to be a normal process. E [ x0 ] = x0 and Var[ x0 ] = 0 if x0 is a constant. The Ornstein-Uhlenbeck process has the following mean reversion property. When X > 0, X is pulled toward zero. When X < 0, it is pulled toward zero again.

Page 522

A generalized version: dX = ( X ) dt + dW, where , 0. Given X (t0 ) = x0 , a constant, it is known that E [ X (t) ] Var[ X (t) ] for t0 t. = = + (x0 ) e(tt0 ) , ] 2 [ 2(tt0 ) 1e , 2 (58)

Page 523

The mean and standard deviation are roughly and / 2 , respectively. For large t, the probability of X < 0 is extremely unlikely in any nite time interval when > 0 is large relative to / 2 . The process is mean-reverting. X tends to move toward . Useful for modeling term structure, stock price volatility, and stock price return.

Page 524

Square-Root Process

Suppose X is an Ornstein-Uhlenbeck process. Itos lemma says V X 2 has the dierential, dV = 2X dX + (dX )2 = 2 V ( V dt + dW ) + 2 dt ( ) 2 = 2V + dt + 2 V dW,

a square-root process.

Page 525

In general, the square-root process has the stochastic dierential equation, dX = ( X ) dt + X dW, where , 0 and X (0) is a nonnegative constant. Like the Ornstein-Uhlenbeck process, it possesses mean reversion: X tends to move toward , but the volatility is proportional to X instead of a constant.

Page 526

When X hits zero and 0, the probability is one that it will not move below zero. Zero is a reecting boundary. Hence, the square-root process is a good candidate for modeling interest rates.a The Ornstein-Uhlenbeck process, in contrast, allows negative interest rates. The two processes are related (see p. 525).

a Cox,

Page 527

The random variable 2cX (t) follows the noncentral chi-square distribution,a ( ) 4 t , 2 cX (0) e , 2 where c (2/ 2 )(1 et )1 . Given X (0) = x0 , a constant, ) ( t t E [ X ( t) ] = x 0 e , + 1e ) ) 2 ( 2 ( t 2t t 2 e + 1e , Var[ X (t) ] = x0 e 2 for t 0.

a William

Page 528

The most popular stochastic model for stock prices has been the geometric Brownian motion, dS = dt + dW. S The continuously compounded rate of return X ln S follows dX = ( 2 /2) dt + dW by Itos lemma.a

a See

also Eq. (56) on p. 513. Also consistent with Lemma 9 (p. 259).

Page 529

The more general deterministic volatility model posits dS = (rt qt ) dt + (S, t) dW, S where (S, t) is called the local volatility function.a The trees for the deterministic volatility model are called implied trees.b Their construction requires option prices at all strike prices and maturities.

and Kani (1994). b Derman and Kani (1994); Dupire (1994); Rubinstein (1994).

a Derman

Page 530

How to construct an implied tree with eciency, valid probabilities and stability remains open for a long time.a Reasons may include: noise and nonsynchrony in data, arbitrage opportunities in the smoothed and interpolated/extrapolated implied volatility surface, wrong model, etc. Numerically, the inversion problem is an ill-posed problem. It is partially solved recently.b

and Kani (1994); Derman, Kani, and Chriss (1996); Coleman, Kim, Li, and Verma (2000); Ayache, Henrotte, Nassar, and Wang (2004); Kamp (2009). b February 12, 2013.

a Derman

Page 531

Theoretically,a (X, T ) = 2

2 C T C + (rT qT )X X + qT C 2C X 2 X 2

(59)

where C is the call price at time t with strike price X and maturity date T . In practice, like implied trees and for similar reasons, (K, T )2 may have spikes, vary wildly, or even be negative. Worse, the appearance of 2 C/X 2 in the denominator results in numerical instability.

a Dupire

Page 532

The relation between the implied volatility surface (X, T ) and the local volatility surface (X, T ) isa

[ ] + 2 T + (rT qT )X X [ ], (X, T )2 = ( ) ( )2 Xy 2 X 2 1 X + X X 4 + X X 2 X

2

T

t

(qs rs ) ds.

Although this version may be more stable than Eq. (59) on p. 532, it is expected to suer from similar problems.

(1996); Andersen and Brotherton-Ratclie (1998); Gatheral (2003); Wilmott (2006); Kamp (2009).

a Andreasen

Page 533

Page 534

I have hardly met a mathematician who was capable of reasoning. Plato (428 B.C.347 B.C.) Fischer [Black] is the only real genius Ive ever met in nance. Other people, like Robert Merton or Stephen Ross, are just very smart and quick, but they think like me. Fischer came from someplace else entirely. John C. Cox, quoted in Mehrling (2005)

Page 535

The price of any derivative on a non-dividend-paying stock must satisfy a partial dierential equation (PDE). The key step is recognizing that the same random process drives both securities. As their prices are perfectly correlated, we gure out the amount of stock such that the gain from it osets exactly the loss from the derivative. The removal of uncertainty forces the portfolios return to be the riskless rate. PDEs allow many numerical methods to be applicable.

Page 536

Assumptionsa

The stock price follows dS = S dt + S dW . There are no dividends. Trading is continuous, and short selling is allowed. There are no transactions costs or taxes. All securities are innitely divisible. The term structure of riskless rates is at at r. There is unlimited riskless borrowing and lending. t is the current time, T is the expiration time, and T t.

and Taleb (2005) summarizes criticisms on these assumptions and the replication argument.

a Derman

Page 537

Let C be the price of a derivative on S . From Itos lemma (p. 506), ( ) 2 C C C 1 C dC = S + + 2 S 2 dt + S dW. 2 S t 2 S S The same W drives both C and S . Short one derivative and long C/S shares of stock (call it ). By construction, = C + S (C/S ).

Page 538

The change in the value of the portfolio at time dt isa C d = dC + dS. S Substitute the formulas for dC and dS into the partial dierential equation to yield ) ( 2 1 C C 2 S 2 d = dt. 2 t 2 S As this equation does not involve dW , the portfolio is riskless during dt time: d = r dt.

a Mathematically

Page 539

So ( C 1 C + 2 S 2 t 2 S 2

2

( ) C dt = r C S dt. S

Equate the terms to nally obtain C C 1 2 2 2C + rS + S = rC. 2 t S 2 S When there is a dividend yield q , C 1 2 2 2C C + (r q ) S + S = rC. t S 2 S 2

Page 540

Rephrase

The Black-Scholes dierential equation can be expressed in terms of sensitivity numbers, + rS + 1 2 2 S = rC. 2 (60)

Identity (60) leads to an alternative way of computing numerically from and . When a portfolio is delta-neutral, 1 2 2 + S = rC. 2 A denite relation thus exists between and .

Page 541

[Black] got the equation [in 1969] but then was unable to solve it. Had he been a better physicist he would have recognized it as a form of the familiar heat exchange equation, and applied the known solution. Had he been a better mathematician, he could have solved the equation from rst principles. Certainly Merton would have known exactly what to do with the equation had he ever seen it. Perry Mehrling (2005)

Page 542

Add the new variable A(t) t

0

S (u) du.

Then the value V of the Asian option satises this two-dimensional PDE:a V V 1 2 2 2V V + rS + S +S = rV. t S 2 S 2 A The terminal conditions are ( ) A V (T, S, A) = max X, 0 T ) ( A V (T, S, A) = max X , 0 T

a Kemna

Page 543

The two-dimensional PDE produces algorithms similar to that on pp. 357. But one-dimensional PDEs are available for Asian options.a For example, Ve ce r (2001) derives the following PDE for Asian calls: ( )2 2 ( ) t 1 T z 2u u t u +r 1 z + =0 2 t T z 2 z with the terminal condition u(T, z ) = max(z, 0).

a Rogers

Page 544

For Asian puts: (t )2 2 ( ) 2u u t u T 1z +r 1z + =0 2 t T z 2 z with the same terminal condition. One-dimensional PDEs lead to highly ecient numerical methods.

Page 545

Hull and White (1987) postulate the following model, dS S dV = r dt + V dW1 , = v V dt + bV dW2 .

Above, V is the instantaneous variance. They assume v depends on V and t (but not S ).

Page 546

Hagan, Kumar, Lesniewski, and Woodward (2002) postulate the following model, dS S dV for 0 1. A nice feature of this model is that the implied volatility surface has a compact approximate closed form. = r dt + S V dW1 , = bV dW2 ,

Page 547

Hilliard and Schwartz (1996) postulate the following general model, dS S dV = r dt + f (S )V a dW1 , = (V ) dt + bV dW2 ,

Page 548

Blacher (2002) postulates the following model, dS S d = = r dt + 1 + (S S0 ) + (S S0 ) ( ) dt + dW2 . [

2

dW1 ,

Page 549

Heston assumes the stock price follows dS S dV = ( q ) dt + V dW1 , = ( V ) dt + V dW2 . (61) (62)

V is the instantaneous variance, which follows a square-root process. dW1 and dW2 have correlation . The riskless rate r is constant. It may be the most popular continuous-time stochastic-volatility model.

a Heston

(1993).

Page 550

dW1 dW2

Page 551

Under the risk-neutral probability measure Q, both W1 and W2 are Wiener processes.

Page 552

Dene

(u, ) = exp { u(ln S + (r q ) ) [ ] d 1 ge + 2 ( u d) 2 ln 1g ( )} 2 d v ( u d) 1 e + , 1 ged (u )2 2 (u u2 ) , ( u d)/( u + d).

d g

= =

Page 553

The formulas area

[ C = S X (u , ) 1 1 + Re du 2 0 uSer [ ( u ) ] X ( u, ) 1 1 Xer + Re du , 2 0 u [ ( ) ] u X (u, ) 1 1 Xer Re du , 2 0 u [ ( u ) ] X (u , ) 1 1 S Re du , r 2 0 uSe

where = 1 and Re(x) denotes the real part of the complex number x.

by Mr. Chen, Chun-Ying (D95723006) on August 17, 2008 and Mr. Liou, Yan-Fu (R92723060) on August 26, 2008.

a Contributed

Page 554

How to explain the October 1987 crash? Stochastic-volatility models require an implausibly high-volatility level prior to and after the crash. Merton (1976) proposed jump models. Discontinuous jump models in the asset price can alleviate the problem somewhat.

a Eraker

(2004).

Page 555

But if the jump intensity is a constant, it cannot explain the tendency of large movements to cluster over time. This assumption also has no impacts on option prices. Jump-diusion models combine both. E.g., add a jump process to Eq. (61) on p. 550.

Page 556

But they still do not adequately describe the systematic variations in option prices.a Jumps in volatility are alternatives.b E.g., add correlated jump processes to Eqs. (61) and Eq. (62) on p. 550. Such models allow high level of volatility caused by a jump to volatility.c

(2000) and Pan (2002). b Due, Pan, and Singleton (2000). c Eraker, Johnnes, and Polson (2000).

a Bates

Page 557

A few stochastic-volatility models suer from subexponential (c n ) tree size. Examples include the Hull-White model (1987) and the Hilliard-Schwartz model (1996).a Future research may extend this negative result to more stochastic-volatility models. We suspect many GARCH option pricing models entertain similar problems.b

(R98723059) (2012). b Chen (R95723051) (2008); Chen (R95723051), Lyuu, and Wen (D94922003) (2011).

a Chiu

Page 558

Hedging

Page 559

When Professors Scholes and Merton and I invested in warrants, Professor Merton lost the most money. And I lost the least. Fischer Black (19381995)

Page 560

Delta Hedge

The delta (hedge ratio) of a derivative f is dened as f /S . Thus f S for relatively small changes in the stock price, S . A delta-neutral portfolio is hedged as it is immunized against small changes in the stock price. A trading strategy that dynamically maintains a delta-neutral portfolio is called delta hedge.

Page 561

Delta changes with the stock price. A delta hedge needs to be rebalanced periodically in order to maintain delta neutrality. In the limit where the portfolio is adjusted continuously, perfect hedge is achieved and the strategy becomes self-nancing.

Page 562

We want to hedge N short derivatives. Assume the stock pays no dividends. The delta-neutral portfolio maintains N shares of stock plus B borrowed dollars such that N f + N S B = 0. At next rebalancing point when the delta is , buy N ( ) shares to maintain N shares with a total borrowing of B = N S N f . Delta hedge is the discrete-time analog of the continuous-time limit and will rarely be self-nancing.

Page 563

Example

A hedger is short 10,000 European calls. = 30% and r = 6%. This calls expiration is four weeks away, its strike price is $50, and each call has a current value of f = 1.76791. As an option covers 100 shares of stock, N = 1,000,000. The trader adjusts the portfolio weekly. The calls are replicated well if the cumulative cost of trading stock is close to the call premiums FV.a

a This

Page 564

Example (continued)

As = 0.538560, N = 538, 560 shares are purchased for a total cost of 538,560 50 = 26,928,000 dollars to make the portfolio delta-neutral. The trader nances the purchase by borrowing B = N S N f = 25,160,090 dollars net.a The portfolio has zero net value now.

takes the hedging viewpoint an alternative. See an exercise in the text.

a This

Page 565

Example (continued)

At 3 weeks to expiration, the stock price rises to $51. The new call value is f = 2.10580. So the portfolio is worth N f + 538,560 51 Be0.06/52 = 171, 622 before rebalancing.

Page 566

Example (continued)

A delta hedge does not replicate the calls perfectly; it is not self-nancing as $171,622 can be withdrawn. The magnitude of the tracking errorthe variation in the net portfolio valuecan be mitigated if adjustments are made more frequently. In fact, the tracking error over one rebalancing act is positive about 68% of the time, but its expected value is essentially zero.a The tracking error at maturity is proportional to vega.b

and Emanuel (1980). b Kamal and Derman (1999).

a Boyle

Page 567

Example (continued)

In practice tracking errors will cease to decrease beyond a certain rebalancing frequency. With a higher delta = 0.640355, the trader buys N ( ) = 101, 795 shares for $5,191,545. The number of shares is increased to N = 640, 355.

Page 568

Example (continued)

The cumulative cost is 26,928,000 e0.06/52 + 5,191,545 = 32,150,634. The portfolio is again delta-neutral.

Page 569

Option value S (1) 4 3 2 1 0 50 51 53 52 54 f (2) 1.7679 2.1058 3.3509 2.2427 4.0000 Delta (3) 0.53856 0.64036 0.85578 0.83983 1.00000

Change in delta

The total number of shares is 1,000,000 at expiration (trading takes place at expiration, too).

Page 570

Example (concluded)

At expiration, the trader has 1,000,000 shares. They are exercised against by the in-the-money calls for $50,000,000. The trader is left with an obligation of 51,524,853 50,000,000 = 1,524,853, which represents the replication cost. Compared with the FV of the call premium, 1,767,910 e0.064/52 = 1,776,088, the net gain is 1,776,088 1,524,853 = 251,235.

Page 571

Dene the dollar gamma as S 2 . The change in value of a delta-hedged long option position after a duration of t is proportional to the dollar gamma. It is about (1/2)S 2 [ (S/S )2 2 t ]. (S/S )2 is called the daily realized variance.

Page 572

Let the rebalancing times be t1 , t2 , . . . , tn . Let Si = Si+1 Si . The total tracking error at expiration is about [( ] ) n 1 2 2 Si r (T ti ) Si i 2 t , e 2 Si i=0 The tracking error is path dependent.

Page 573

The tracking error n over n rebalancing acts (such as 251,235 on p. 571) has about the same probability of being positive as being negative. Subject to certain regularity conditions, the b 2 root-mean-square tracking error E [ n ] is O(1/ n ). The root-mean-square tracking error increases with at rst and then decreases.

Kogan, and Lo (2000). b See also Grannan and Swindle (1996).

a Bertsimas,

Page 574

Delta-Gamma Hedge

Delta hedge is based on the rst-order approximation to changes in the derivative price, f , due to changes in the stock price, S . When S is not small, the second-order term, gamma 2 f /S 2 , helps (theoretically).a A delta-gamma hedge is a delta hedge that maintains zero portfolio gamma, or gamma neutrality. To meet this extra condition, one more security needs to be brought in.

a See

Page 575

Suppose we want to hedge short calls as before. A hedging call f2 is brought in. To set up a delta-gamma hedge, we solve

N f + n1 S + n2 f2 B N + n1 + n2 2 0 N + 0 + n2 2 0 = = = 0 0 0 (self-nancing), (delta neutrality), (gamma neutrality),

Page 576

Other Hedges

If volatility changes, delta-gamma hedge may not work well. An enhancement is the delta-gamma-vega hedge, which also maintains vega zero portfolio vega. To accomplish this, one more security has to be brought into the process. In practice, delta-vega hedge, which may not maintain gamma neutrality, performs better than delta hedge.

Page 577

Trees

Page 578

I love a tree more than a man. Ludwig van Beethoven (17701827) And though the holes were rather small, they had to count them all. The Beatles, A Day in the Life (1967)

Page 579

The combinatorial method can often cut the running time by an order of magnitude. The basic paradigm is to count the number of admissible paths that lead from the root to any terminal node. We rst used this method in the linear-time algorithm for standard European option pricing on p. 248. We will now apply it to price barrier options.

Page 580

Imagine a particle at position (0, a) on the integral lattice that is to reach (n, b). Without loss of generality, assume a > 0 and b 0. This particles movement: (i, j ) * (i + 1, j + 1) up move S Su j (i + 1, j 1) down move S Sd

a Andr e

(1887).

Page 581

=

=

>

Page 582

For a path from (0, a) to (n, b) that touches the x axis, let J denote the rst point this happens. Reect the portion of the path from (0, a) to J . A path from (0, a) to (n, b) is constructed. It also hits the x axis at J for the rst time. The one-to-one mapping shows the number of paths from (0, a) to (n, b) that touch the x axis equals the number of paths from (0, a) to (n, b).

Page 583

A path of this kind has (n + b + a)/2 down moves and (n b a)/2 up moves. Hence there are ( ) = ( ) (63)

n

n+a+b 2

n

nab 2

Page 584

Focus on the down-and-in call with barrier H < X . Assume H < S without loss of generality. Dene

a h ln(X/S ) n + , 2 2 t ln(H/S ) ln (H/ (Sdn )) n = . + ln(u/d) 2 2 t = ln (X/ (Sd )) ln(u/d)

n

Suh dnh is the terminal price h is such that H that is closest to, but does not exceed H . Sua dna is the terminal price a is such that X that is closest to, but is not exceeded by X .

Page 585

The true barrier is replaced by the eective barrier H in the binomial model. A process with n moves hence ends up in the money if and only if the number of up moves is at least a. The price Suk dnk is at a distance of 2k from the lowest possible price Sdn on the binomial tree. Suk dnk = Sdk dnk = Sdn2k . (64)

Page 586

5K @

5

=

D

: 0

5K = @ 5K D @

Page 587

The number of paths from S to the terminal price (n) j nj Su d is j , each with probability pj (1 p)nj . With reference to p. 587, applied with a = n 2h on p. 584 by treating the Therefore, ( the reection principle can be and b = 2j 2h in Eq. (63) line as the x axis. H ) = ( )

n

n+(n2h)+(2j 2h) 2

n n 2h + j

Page 588

The terminal price Suj dnj is reached by a path that hits the eective barrier with probability ( ) n pj (1 p)nj . n 2h + j The option value equals

2h (

j =a n n2h+j

p (1 p)

j

nj

Su d

j nj

) . (65)

Rn

a Lyuu

(1998).

Page 589

Convergence of BOPM

Equation (65) results in the sawtooth-like convergence shown on p. 337. The reasons are not hard to see. The true barrier most likely does not equal the eective barrier. The same holds between the strike price and the eective strike price. The issue of the strike price is less critical. But the issue of the barrier is not negligible.

Page 590

Convergence is actually good if we limit n to certain values191, for example. These values make the true barrier coincide with or just above one of the stock price levels, that is, H Sdj = Sej /n for some integer j . The preferred ns are thus n= 2 , j = 1, 2, 3, . . . (ln(S/H )/(j ))

Page 591

There is only one minor technicality left. We picked the eective barrier to be one of the n + 1 possible terminal stock prices. However, the eective barrier above, Sdj , corresponds to a terminal stock price only when n j is even.a To close this gap, we decrement n by one, if necessary, to make n j an even number.

is because j = n 2k for some k by Eq. (64) on p. 586. Of course we could have adopted the form Sdj (n j n) for the eective barrier. It makes a good exercise.

a This

Page 592

The preferred ns are now if j is even n= , 1 otherwise j = 1, 2, 3, . . . , where

2

(ln(S/H )/(j ))

Page 593

5.65

5.6

5.55

5.5

Page 594

Practical Implications

Now that barrier options can be eciently priced, we can aord to pick very large ns (p. 596). This has profound consequences (to explain later).

Page 595

Combinatorial method Value Time (milliseconds) 0.30 0.90 2.00 3.60 5.60 8.00 11.10 15.00 19.40 24.70 30.20 36.70 43.70 44.10 51.60 68.70 76.70 86.90 97.20

21 84 191 342 533 768 1047 1368 1731 2138 2587 3078 3613 4190 4809 5472 6177 6926 7717

5.507548 5.597597 5.635415 5.655812 5.652253 5.654609 5.658622 5.659711 5.659416 5.660511 5.660592 5.660099 5.660498 5.660388 5.659955 5.660122 5.659981 5.660263 5.660272

Page 596

Pricing is prohibitively time consuming when S H because n 1/ ln2 (S/H ). This is called the barrier-too-close problem. This observation is indeed true of standard quadratic-time binomial tree algorithms. But it no longer applies to linear-time algorithms (see p. 598). This binomial model is O(1/ n) convergent in general but O(1/n) convergent when the barrier is matched.a

a Lin

Page 597

Barrier at 95.0 n Value . . . 2743 3040 3351 3678 4021 True 2.56095 2.56065 2.56098 2.56055 2.56152 2.5615 31.1 35.5 40.1 43.8 48.1 Time n

Page 598

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