Introduction to Options and Futures

Options
(& others)
Hedging
Financial with…
markets and
Swaps
corporate
applications
Pricing…
Forwards
and Futures
¡ Modelling stochastic process for stock prices
¡ Geom. Brownian motion and log-normal 𝑆
¡ Itô’s lemma
¡ The Black-Scholes equation
¡ Assumption: Volatility 𝜎 is a constant
¡ Let 𝑑𝑆 = 𝜇𝑆𝑑𝑡 + 𝜎𝑆𝑑𝑧 be the underlying
price process, and consider a derivative with
price 𝑓 𝑆, 𝑡 and terminal payoff 𝑋 𝑆!
¡ Design a risk-free (self-financing) portfolio of
Δ units of the underlying and short one unit of
the derivative
¡ As 𝜋 is self-financing
¡ As 𝜋 is also risk-free
¡ Risk-free 𝜋 must earn the risk-free rate 𝑟
¡ Putting it all together:
¡ Putting it all together and if the terminal payoff
of the derivative is 𝑋(𝑆(𝑇)):

"
𝜕𝑓 𝜕𝑓 " "
1 𝜕 𝑓 𝑡 ∈ [0, 𝑇[
2 𝜕𝑡 + 𝑟𝑆 + 𝜎 𝑆 "
= 𝑟𝑓
𝜕𝑆 2 𝜕𝑆 ∀𝑆 > 0
𝑓 𝑇, 𝑆 = 𝑋(𝑆) ∀𝑆 > 0
¡ However, solving a PDE to find the value
function 𝑓 of a derivative is challenging
¡ It turns out that "the" solution in 𝑡 = 0 to the
BS PDE can be written as:
𝑓 𝑆# , 0 = 𝑒 $%! 𝐸 ∗ 𝑋(𝑆! )
'!
with 𝑆! = 𝑆# exp 𝑟− 𝑇 + 𝜎𝑧!
"
¡ At any other intermediate date 𝑡 ∈ [0, 𝑇[
𝑓 𝑆( , 𝑡 = 𝑒 $%(!$() 𝐸 ∗ 𝑋 𝑆! |ℱ(
'!
with 𝑆! = 𝑆( exp 𝑟− (𝑇 − 𝑡) + 𝜎(𝑧! − 𝑧( )
"

where 𝐸 ∗ ⋅ |ℱ( is a conditional expected value

¡ Remember forwards: 𝑋 𝑆! = 𝑆! − 𝐹#
¡ How do you set 𝐹# ?
¡ Remember forwards: 𝑋 𝑆! = 𝑆! − 𝐹#
¡ The value at any intermediate date is
𝑓 𝑆( , 𝑡 = 𝑆 𝑡 − 𝐹# 𝑒 $%(!$()
does it satisfy the BS PDE?
¡ For a European call:
𝑐( = 𝑆( 𝑁 𝑑+ − 𝐾𝑒 $% !$(
𝑁 𝑑"

" $!
,- . %. !$(
# !
𝑑+ = ; 𝑑" = 𝑑+ − 𝜎 𝑇 − 𝑡
' !$(

¡ For a European put:

𝑝( = 𝐾𝑒 $% !$(
𝑁 −𝑑" − 𝑆( 𝑁 −𝑑+
 ¡ For a European call:
𝑐( = 𝑆( 𝑁 𝑑+ − 𝐾𝑒 $% !$(
𝑁 𝑑"

" $!
,- . %. !$(
# !
𝑑+ = ; 𝑑" = 𝑑+ − 𝜎 𝑇 − 𝑡
' !$(
Stock price
today Annualized
Strike price Annualized
volatility Time to
risk-free
maturity
rate
(years)
¡ 𝑁 𝑥 is the cumulative standard normal
distribution
¡ 𝑁 𝑥 is the cumulative standard normal
distribution
200
Call option price ¡ Recall 𝑆 ≥ 𝒄 ≥
Lower bound
Upper bound
𝑆 − 𝐾𝑒 $%!
150

100

50

0
0 50 100 150 200
¡ The payoff of an European call option is
.
𝑋 𝑆! = 𝑆! − 𝐾
¡ Its price at inception is
𝑐# = 𝑒 $%! 𝐸 ∗ 𝑋 𝑆! = 𝑒 $%! 𝐸 ∗ 𝑆! − 𝐾 .
¡ The second expected value is easy to
compute
¡ The first expected value is less easy to
compute
¡ Putting everything together

¡ Exploiting the Markov property

¡ Non-dividend paying stock with expected
return 𝜇 and volatility 𝜎. The bank offers a
derivative which pays ln 𝑆! at maturity 𝑇.
§ Use R-N valuation to obtain the price of the
derivative at time 𝑡
§ Verify that the B-S equation is satisfied
¡ As for forwards, two approaches:
a) Lump-sum dividend 𝐷 during life of the option

a) Continuous yield 𝑞 over the life of the option

¡ European call, 𝑆# = $50, 𝑇 = 15 months, 𝑟 =
8%, 𝐾 = $55, 𝜎 = 25%. In 4 and 10 months,
$1.50 dividends are expected. What is the
price of the option?
¡ Modelling stochastic process for stock prices
¡ Geom. Brownian motion and log-normal 𝑆
¡ Itô’s lemma
¡ The Black-Scholes equation
¡ Assumption: Volatility 𝜎 is a constant
¡ A European call option on a non-dividend
paying stock has 𝑐 = $2.50. 𝑆# = $15, 𝐾 =
$13, 𝑇 = 0.25, 𝑟 = 5% per annum. What is
𝜎?
𝝈 𝒄 𝝈 Not possible to invert the
0.2 Black-Scholes formula.
0.3 We can turn to an
0.4 iterative procedure.
¡ We just defined implied volatility – the 𝜎 such
that the market price of the option equals its
Black-Scholes price
¡ Because 𝜕𝑐/𝜕𝜎 > 0 and 𝜕𝑝/𝜕𝜎 > 0 always,
prices and volatility are 1:1
¡ Traders and brokers often quote implied
volatilities directly
¡ The B-S model assumes that 𝜎 should not
change as a function of the strike price 𝐾
𝜎

𝐾
 SPX put implied volatility
0.40

ATM
0.30

0.20

“Overprice”
OTM puts
0.10 “Underprice”
ITM puts

0.00
2200 2300 2400 2500 2600 2700 2800 2900
Strike price
Source: S&P500 puts quotes, December 2017, http://www.optionistics.com/f/volatility_skew
Source: http://www.optionistics.com/f/volatility_skew
Source: http://www.optionistics.com/f/volatility_skew
 Dow Jones Industrial Average
3000

2700

2400

19 Oct 1987:
2100 22.6% drop
in one day

1800

1500
Jan-87 Mar-87 May-87 Jul-87 Sep-87 Nov-87 Jan-88 Mar-88 May-88 Jul-88

Source: Datastream
1987 crash

Source: Benzoni, Collin-Dufresne, and Goldstein (2011)

¡ CBOE Volatility Index (VIX), based on real-
time prices of options on S&P500 index
¡ Designed to reflect investor consensus view
of future (30-day) stock market volatility
¡ “Investor fear gauge”?
§ During periods of distress, option prices rise
§ Why?
80

60

40

20

0
2000 2003 2006 2009 2012 2015

Source: Datastream
45

38

30

23

15
Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02

Source: Datastream
80

60

40

20

0
Apr-08 May-08 Jun- 08 Jul-08 Aug- 08 Sep-08 Oct-08 Nov-08 Dec-08

Source: Datastream
¡ How should we modify the Black-Scholes
framework to account for volatility
smiles/smirks?
¡ Two approaches:
a) “Jumps”

b) Stochastic volatility