Quantitative Methods in Finance

MSc. in Finance
Fall 2020

Instructor: Romain Deguest

Case Study 4: Monte Carlo Simulations

You are a trader of an investment bank who has to price and delta-hedge a short position in a put option on
the S&P 500 issued on 2020-06-30. The put option has strike K = $3, 000 and a maturity equal to 3 months
(T = 0.25 year).
In order to do so, you assume that the S&P 500 follows the Black-Scholes and Merton model with
constant drift µ and volatility σ
dSt = St [µdt + σdWt ] .

The constant short-term interest rate r is assumed to be equal to 0.5%. First, you will have to estimate
the parameters of the model: µ and σ and then you will price the put option using the closed-form formula
available with the BSM model and by running Monte Carlo simulations.

Instructions
This case study will be started during the online group work session following the lecture. Your group is
expected to work on this project during the session and at home before submission. You will be able to ask
any questions to help you complete the case study during the group online work sessions, the Q&A online
sessions, and on the Blackboard discussion board.
Assignments must be submitted using the R template provided (in both the .Rmd format and the .pdf
format obtained by using the Knit button in RStudio), otherwise assignment will receive a 0.
Late submissions will receive a 0.

1 Calibration of the Model (30 marks)

a. (10 marks) Download the S&P 500 equity index (yahoo ticker: ˆGSPC) from yahoo finance over the
period between 2005-06-29 and 2020-07-01 and compute its daily log-returns. What are the S&P 500
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annualized average log-return, and volatility over the entire data-set (use ∆ = 252 for the annualiza-
tion)?
b. (10 marks) Use the moving average model (MA) to estimate the volatility of the S&P 500 with lag
n = 60 over the entire data-set. Compare the volatility estimate you obtain on 2020-06-30 to the
volatility you obtained in (a) over the entire data-set. Why are they different and which one should
you use to plug in the Black-Scholes and Merton model to price the put option?

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 c. (10 marks) We have assumed the constant short-term interest rate to be equal to 0.5%. What data
source could you have used to provide an estimate for the short-term interest rate? When you use
Monte Carlo simulations to compute prices of derivatives, should you simulation the underlying price
under the risk-neutral probability or real-world probability? Why?

2 Price of a Put Option with Monte Carlo (70 marks)

In the Black-Scholes and Merton model, the formula for the put option is given by

P0 = Ke−rT N (−d2 ) − S0 N (−d1 )

where d1 and d2 have the same definition as the one used in the call price formula.

a. (10 marks) Implement the closed-form formula of the BSM model to price the put option. Plot the
put option price for S&P 500 spot prices ranging from $2,000 to $4,000.
b. (20 marks) Compute the Delta and Gamma of the put and plot them on two seperate graphs for a
range of spot S&P 500 prices ranging from $2,000 to $4,000. The Gamma represents the sentivity of
the Delta, i.e. the sensitivity of the Delta-hedging strategy that the investment bank has to implement
in order to replicate the put payoff. What can you say about the sensitivity of the put replicating
strategy when the option is at the money, i.e. when the spot price S0 is around the strike?
c. (20 marks) Run M = 100, 000 Monte Carlo simulations to model the evolution of the S&P 500 starting
at the value of the S&P 500 on 2020-06-30, and over a horizon of 3 months. You can adopt the Euler
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discretization scheme applied to the log-price and using a monthly time-step (∆t = 12 year). In each
of the 100,000 scenarios obtained, compute the value of the put option and finally report the average
value mb of the put option prices obtained over all the simulations. Compare your result to the exact
put option price.
d. (10 marks) Run the previous Monte Carlo simulations to compute the put option price with M = 10, 000
and M = 1, 000, 000 trajectories. Compute for each of the three values of M the 95% confidence
interval. What do you observe? where sb is the standard deviation of the put prices among the 100,000
simulations.
e. (10 marks) Explain briefly how you would delta-hedge the put option.