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- BNP_April_2012
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NDEX

Commerzbank ........................................................................................4 1.1 1.2 1.3 Markets in Corporates & Markets ......................................................5 The profit and loss (P&L) ...................................................................8 The Book Open .................................................................................8

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Structured Equity Products and the People who buy them ...............9 2.1 What is a structured product?............................................................9 2.1.1 Manufacturing aspects of structured products............................9 2.1.2 Types of structured product ......................................................10 2.2 The market for structured products..................................................11 2.2.1 Intermediaries in the structured product market .......................12 2.3 Summary .........................................................................................13

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Derivatives............................................................................................15 3.1 3.2 3.3 3.4 Vanilla options .................................................................................15 Barrier options .................................................................................17 Combining vanilla products..............................................................18 Put / Call parity ................................................................................19 Stochastic Differential Equations (SDEs).........................................20 Lognormal returns for asset prices ..................................................20 The assumption for the Black-Scholes model..................................20 The Black-Scholes equation ............................................................21 Black-Scholes closed formulas........................................................21

4

Black-Scholes Model ...........................................................................20 4.1 4.2 4.3 4.4 4.5

5 6

The Forward .........................................................................................22 Correlation............................................................................................23 6.1 6.2 6.3 How to calculate historical correlation..............................................23 Implied correlation ...........................................................................24 Correlation term structure and correlation skew ..............................24 How to calculate historical volatility .................................................26 Implied volatility ...............................................................................27 Basket volatility................................................................................27 How to calculate the volatility of a basket ........................................27 Volatility term structure ....................................................................28 Skew / Smile....................................................................................28

7

Volatility and Variance.........................................................................26 7.1 7.2 7.3 7.4 7.5 7.6

8 9 10

Quanto and Compo Options ...............................................................30 The Greeks ...........................................................................................32 The Hedge ............................................................................................34

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Derivatives

11

Sensitivities of Exotic Options ...........................................................35 The Intrinsic – Time Value Relationship ..........................................35 The pragmatic approach to estimate sensitivities ............................36

11.1 11.2 12 13

Being long / short ................................................................................37 Swaps, Notes and Certificates............................................................38 Swaps..............................................................................................38 Equity-linked swaps .........................................................................38 Bonds ..............................................................................................39 Equity Notes ....................................................................................39

13.1 13.2 13.3 13.4 14

What are Models ..................................................................................41

14.1 The calibration process....................................................................41 14.2 How all derivative pricing models actually work...............................42 14.3 Black Vanilla ....................................................................................45 14.4 Black Diffusion.................................................................................45 14.5 Vskew ..............................................................................................45 14.6 Pskew ..............................................................................................46 14.7 Local Volatility..................................................................................46 14.8 Stochastic volatility ..........................................................................46 14.8.1 The Heston model ....................................................................47 14.8.2 The Hagan model .....................................................................48 14.8.3 The Scott-Chesney model ........................................................48 15 Cliquets.................................................................................................49 15.1 Volga (or Convexity) ........................................................................49 15.2 Types of Cliquets .............................................................................51 15.2.1 Classic cliquet...........................................................................51 15.2.2 Ratchet .....................................................................................52 15.2.3 Reverse cliquet.........................................................................54 15.2.4 Napoleon ..................................................................................57 15.2.5 Accumulator .............................................................................58 15.2.6 Comparing cliquets...................................................................59 16 The Concept of Risk ............................................................................60 Delta Risk ........................................................................................60 Vega risk..........................................................................................60 Correlation risk ................................................................................61 Second order risks...........................................................................61 Digital call option .............................................................................62 Barrier shifts ....................................................................................63 Evaluating the discontinuities ..........................................................64 How to determine options prices .....................................................66 Closed formulas...............................................................................67 Finite difference and Trees ..............................................................67 The Monte Carlo method .................................................................67 16.1 16.2 16.3 16.4 17 17.1 17.2 17.3 18 18.1 18.2 18.3 18.4

Discontinuities .....................................................................................62

Pricing Techniques..............................................................................66

2

Derivatives

18.4.1 18.4.2 19 20

How does it work? ....................................................................68 Estimate option prices with the MC method .............................70

How to Avoid Errors ............................................................................71 Hybrid Products ...................................................................................72

20.1 Overview..........................................................................................72 20.2 The impact of stochastic IR .............................................................73 20.3 Specific case studies .......................................................................76 20.3.1 Equity – Interest Rates linked payoff ........................................76 21 DIVA ......................................................................................................80 Accessing the data in the trading databases ...................................80 DIVA Objects ...................................................................................80 Pricing complex exotic products ......................................................81 Introduction to EasyDIVA.................................................................82 Product Description .........................................................................84 Product Analysis ..............................................................................88 21.1 21.2 21.3 21.4 22 22.1 22.2

Annexe A (Autocallable Products) .....................................................84

3

JP Morgan for example. Reporting lines are not as complex as for big US investment banking giants such as Goldman Sachs. ComDirect (our online broker ) : Philip Lang 4 . Arne Scheehl and David Krentz 3. Merrill Lynch. sale and hedging stages of derivatives.Derivatives 1 Commerzbank Commerzbank. Treasury Services Zentrale Staebe Zentrale Geschaeftsfelder Zentrale Service bereiche Credit Risk Fiancial Controlling Group Compliance Human Resources Asset Management ComDirect Mittelstand Commercial Real Estate Group Treasury Information Technology Transaction Banking Private Banking Retail Corporate & Markets Public Finance Diagram 1.1 YYYYYYYYYYYYYYYYYYYYYYYYY The main internal business areas you will be in contact with during this internship are the following: 1.1 is the one involved in the development. ZPK (our retail in Germany) : Thomas Timmermann. unlike many other financial institutions. ZPB (our private banking in Germany) : Elmar Gehring. Public Finance. Board Direction Private client & Asset management Corporate & Investment Banking Commercial Real Estate. Andreas Muehleck 4. has a relatively simple internal structure. ComInvest (Our Asset management in Germany) : Thomas Roell. The red marked department in Diagram 1. Andreas Muehleck and Stefan Gotsche 2.

3.2 shows the internal divisions of the Investment Banking part of Commerzbank Corporates & Markets. You will be working in the so-called front office which includes six main “teams”: 1. 3. Client Client Client Client Requests New products development Issuer Investment Banking Sales Issuer EMTN Indicative Prices New products development Trading price Structuring Pricing methodology Trading New models Models development Risk control Financial Engineering Risk management Model approval Diagram 1.2 YYYYYYYYYYYYYYYYYYYYYYYYY The trading team is further segmented into different asset class trading desks as can be seen in diagram 1. 2. you will find the Investment Banking department.Derivatives 1. The desk you will be most in contact with are the following: 5 .1 Markets in Corporates & Markets Within Commerzbank Corporates & Markets. 6. 5. 4. Trading Team Sales Team Structuring team EMTN Desk Financial Engineering Team Risk Management Team Diagram 1.

Jorge Masalles) Institutional sales Germany (Thomas Roell. Frank Mohr) Private Banking sales ex Germany (Guillaume Hellier) Private Banking sales Germany (Elmart Gehring.Derivatives 1. Jens Fischer. Fabian Behnke) 6 . Arne Scheehl) CBK’s internal retail (Thomas Timmermann. 2. They are: 1. 6. Institutional sales ex Germany (Jaime Uribe. 5. Frederic Lescaroux) 3. Johannes Neulinger. The complexity of the products sold is another important factor which characterises a given sales team.3 YYYYYYYYYYYYYYYYYYYYYYYYY On the sales side. Single stock trading (Thorsten Moos. 3. Cristoph Hartmann) Diagram 1. Exotic indices trading (Michel Sibert. Carsten Sitter) 2. Andreas Muehleck) External retail (Michael Moll. Nicolas Allano. Exotic stock trading (Bastien Lussault. 4. the teams can be dived by client type.

Derivatives Diagram 1.4 YYYYYYYYYYYYYYYYYYYYYYYYY 7 .

That is. certificate etc) without taking into account any kind of margin. It represents the fair price of that specific security and is defined as: SecurityOffer Pr ice − M arg in Bank − M arg inClient = BookOpen ( BO) 8 . 1. usually. offer financial products to their clients. we’d need € 99 to fully be hedged. At this point a question arises.Derivatives 1. like many other financial institutions. in other words it has to use some more or less complicated mathematical tool to evaluate the price of a given product. By not covering a market exposure. bond. they might incurr losses in cases where their views turn out to be wrong. Where does a bank make its money? The answer to this is relatively simple. This risk has to be hedged away by the trader using techniques that we’ll analyze later on. The price determined is the cost for the trading desk to fully hedge the product. The hedging cost is € 99 and the money earned by the bank is € 1. it will cost the trading desk an amount X to be hedged and at expiry we are left with zero.3 The Book Open The term Book Open (BO) defines the price of a security (swap. How can we then explain the trader’s bonuses at the end of the year? Let’s make an example: consider that the price of a financial instrument is € 99. This means that if they have some specific market exposures they might decide not to cover them. indicated as P&L. neither the one of the bank nor the one of the client (if sold to third parties). Traders. But there is more. once we sell a product at a price X. keeping some risk in their trading books. don’t fully hedge their books. the sum of all the margins determines the profit of a bank. If this is repeated every time a product is sold. The total Profit and Loss. This depends on the level of risk-aversion and on the individual market views of the traders. The price at which the product is sold is now € 100. What banks usually do is that they sell that product at a higher price by applying a margin to the fair value: let’s say € 1. Banks. When a bank sells a product it has to determine what the fair value for that specific financial instrument is. if the model is correct and we exactly hedge the product (we’ll see later what this means). If we proceeded as explained above.2 The profit and loss (P&L) The aim of all companies is to maximize its returns by taking limited level of risks. can be expressed by the following formula: i j P & L = ∑ M arg in Sales + ∑ Positions Trading i =1 j =1 I J i being the total number of products sold and j the total positions held by the trading desk. There is obviously a buffer represented by the sales margin made but considering the amount of positions hold by banks it is easy to understand that losses can occur in large extent.

and the certificate.1 Manufacturing aspects of structured products A structured product is a single security. which is “made” of a bond plus an equity derivative.Derivatives 2 Structured Equity Products and the People who buy them Commerzbank’s equity derivative business is mainly focussed on what are called “structured products” (specifically those linked to equities – there are also interest rate. There are a number of different legal forms that these bonds can take. Whilst these are slightly different legally. 9 . A very simple example would be a bond which paid no coupons during its lifetime. 2. The issuer then brings the product into existence through the legal document which defines the exact obligation that the bond issuer has to bond holders. but at maturity redeemed at an amount equal to 100. with the most common being the Medium Term Note (MTN. all sold as a single legal security. redemption could be below par) but this is not necessarily the case. This very simple product can be decomposed into two financial instruments –a zero coupon bond. consisting of an equity derivative plus a fixed income instrument. credit. This illustrates how a structured product is a “manufactured” product. and other types of structured product but we are not concerned with them here). they are “wrapped” as something else). FX. which has a coupon and / or a redemption value which.1. but not legal to sell many types of bond directly to the public. plus the greater of zero and 70% of the percentage change in the value of an equity index measured over the bond’s lifetime. Strucutured products do not always take the legal form of a bond (in industry parlance. These products are manufactured and bought by a variety of types of investors for a variety of reasons. This is often done for regulatory reasons – in the UK. An investor in the shares of the fund then has an exposure which is identical to having bought all the pieces independently. but the economics are the same. for example. 2. where a fund is set up which buys all the bits of the structured product. which provides the return of 100 at maturity. A structured product can also take the form of an investment fund. is linked to equity prices. it is legal to sell investment funds. with a notional amount of 70% of the bond notional. plus a call option on the equity index. The holder of the bond will almost certainly not retain any physical proof of ownerhsip – their holding will be recorded in some elecronic system such as Clearstream or Euroclear which record securities ownership in accounts in the same way as a bank account records cash ownership. instead of being fixed like a typical bond. this is not particularly important from the point of view of pricing the products. and for all practical purposes they are just bonds. The entity selling the structured product effectively assembles the product by buying (or replicating) the individual pieces.1 What is a structured product? A structured product is a simple concept – it is essentially a bond.e. Often a certificate is a non-principal protected product (i. or sometimes Euro MTN or EMTN).

this will be explained in a later section.1 YYYYYYYYYYYYYYYYYYYYYYYYY This way. Generally the coupon that they pay on the bond reflects both the market’s required level of compensation to take the risk that the issuer of the bond can repay the principal. In order to be able to use as wide a range of issuers as possible. Currency etc. but in a large number of cases Commerzbank will structure and sell a bond which is issued by an external party. However in many cases it is an external institution. and prefer to pay a coupon linked to interest rates. In some cases it is actually this external instution who is Commerzbank’s client rather than the bond investor. the investor has a bond. and Commerzbank has a net postion in the equity-linked derivative element of the bond which is then managed in the equity derivatives trading portfolio.) Bond Issuer Bond issuer sells bond With desired equityLinked payoff to bond investor Bond investor pays bond issuer 100 EUR for the bond at Inception Bond investor Diagram 2. In many cases this is Commerzbank. and pay the coupon stream of their choice (almost always an amount linked to short-term interest rates). the net position of the bond issuer is that they have issued a bond.2 Types of structured product There are many diffferent types of structured product. and with the payoff of their choice.1. 2. issued by the counterparty of their choice. Often the issuer will be Commerzbank’s own treasury department (this is the department of the bank which is responsible for balancing the cashflows arising from the bank’s many different financing. and deposit-taking activities). but the issuer will have preferences on how it pays the coupon – for example some issuers will have costs linked to interest rates. most structured products are manufactured in the following way: Commerzbank ZCM Commerzbank pays Equity-linked amount to Bond issuer at maturity / Over bond lifetime Bond issuer pays Commerzbank Coupon stream in format of Issuers choice (frequency. The motivation for the issuer of any bond is to finance their business activities.Derivatives The issuer of a structured product is the instution which actually issues the bond which constitues the product. but almost all of them fall into one of three broad categories: 10 . rather than a fixed coupon.

2. sidestep note. Often they only replicate the price return of the security. of a bond which redeems at par (in the absence of bankruptcy of the issuer). but once the product is legally transformed through a certificate “wrapper” its new legal nature makes it a permissible investment. in particularly bonds. The premium on the equity put option is then added to the coupon so that the structured product pays a higher coupon. However it is also possible to create a bond whose repayment at maturity is linked to equity prices. although there are sometimes regulatory implications of the use of the word “guaranteed”) products. and want to generate an income stream from taking some equity risk on the downside. is what is generally known as a capital (or principal) protected (or guaranteed. Typically this is because there is credit risk on the issuer of the bond. where the redemption is reduced if equity prices decline. For example. They are widely used by investors who have a positive view of equity. Yield enhancement products are widely used by investors who have a weakly positive view of the market. bonus certificate. plus the time and infrastructure to trade in five hundred stocks at once). Whilst there is no single definition of what exactly a retail investor is. There are a great variety of yield enhancement products which involve the investor taking some sort of downside risk on equities in return for an increased coupon. Yield enhancement products Financial instruments. basket of securities. offer a higher coupon where there is a greater risk of the principal not being repayed in full. autocallable. premium certificate. and simply replicate the exposure that is gained from holding a security. The simplest such instrument would reduce the principal repayment by 1% for every 1% that an equity index dropped over the lifetime of the bond. a particular type of investor may not be able to invest in a particular market. in return for an increased coupon compared to the risk-free coupon. and a short position in an equity put option. Capital protected products The example given in the first section. ie the investor does not receive the benefit of dividends. and many others. or index. Such a bond can be “manufactured” by combining a long position in a simple fixed coupon bond. discount certificate. In this case the cashflow stream that comes from the dividends is used to price These products are used for what is known as “market access”. an investor may not have the time or money to actually invest in the underlying (for example the S&P 500 index cannot be tracked by an investor who does not have several hundred thousand euros. plus a participation in the positive performance of an equity underlying. Some of the names that you will come across are reverse convertible. but who for some reason do not want to take any risk on the equity downside.2 The market for structured products Most structured products which are sold by Commerzbank are ultimately destined for retail investors. or a more efficient investment from the point of view of regulation or tax. it is 11 .Derivatives Delta-1 products These are the simplest structured products of all. Alternatively.

). and issue the necessary structured bond themselves. and sometimes large corporations. If a fee is paid to the distributor. and they can buy much risker and illiquid products. There is generally less regulation covering this market. who spend all their time looking for investments. In most developed markets. through which a large number of structured products are sold via the internal organisation known as ZPK. insurance companies.Derivatives approximately true to say that if somebody has thousands. Institutional investors are often driven by very specific regulatory. Some of these intermediaries do not buy completed structured products.25% per annum which is paid to the intermediary rather than the investor. so the legal form that the product takes may well be its most important feature. In fact many structurers are devoted solely to addressing these types of issues. who have large networks of salespeople and complex admnistration systems which allow them to deal directly with the public. and actually manufacture the product themselves. are the so-called “instutional investors”. They include insurance companies (who need to invest the premium that they receive from selling insurance policies). Some bank products are sold in the form of a “structured deposit”. So Commerzbank does actually sell products directly. or indirectly via the product manufacturer. this is done through an internal counterparty.2. for example. and also regulation) from retail investors are the so-called “high net worth” or “HNW” individuals. depending on the capacity in which they are a client. which is treated as though it were an external client. brokers. they are a retail investor. the fee makes no difference to us. Such intermediaries generally earn their living from fees which they earn in two ways: from the investor directly by selling a bond for 102 EUR when its par value is 100 EUR. fund managers who are allowed to invest in structured products rather than directly into equities and bonds. which is economically the same as a bond. then the present value of this fee is simply deducted from the amount that the investor has to spend on the equity derivative element of the structured product. tax. fund management companies. who invest some of the cash that they hold for liquidity purposes to try and get a higher return than they could from simply putting the cash on deposit. or tens of thousands of euros to invest. of euros to invest. although for the purposes of ZCM.1 Intermediaries in the structured product market Obviously Commerzbank’s equity derivatives division cannot directly service thousands upon thousands of individual retail clients (nor do the regulators allow it to). or millions. and financial advisers. often with some regional segmentation as well. who in simple terms have hundreds of thousands. Instead they will buy the raw derivative pieces of the product. One such intermediary is Commerzbank’s own retail network of high-street branches in Germany. 2. the relationship between banks (and other financial companies) and retail investors is very closely regulated. but has the legal structure of a bank account rather than a bond. the retail market is covered by instutions such as banks. One step up (in terms of wealth. Different groups of clients are covered by different sales teams at Commerzbank. Obviously the level of the fee is related to the level of service offered by the intermediary. 12 . Coverage is also a little confused by the fact that the same company may be covered by more than one sales team. The manufacturer in such a case will structure a bond which has an additional coupon of say 0. These are professional money managers. or accounting concerns as much as they are by the actual economics of the product. Many banks with large retail client-bases but no derivative trading capabililty will do this. From Commerzbank’s point of view. family offices (who act on behalf of the super-rich with billions to invest. often called “ultra” high net worth. At the top. Instead. pension funds (both private and state).

Large manufacturer-distributors like large banks. who may have some limited capacity to manufacture products (but normally not). Some very large financial institutions may well be a client in more than one way. HNWI are generally serviced by a sector of the intermediary market called Private Banks. Structured products fall into one of three broad classes: • • • Simple market-access products Yield enhancement products Capital protected products 13 . These are effectively high-powered advisers and brokers. employee share schemes. for example. They are professional market counterparties so the regulatory burden of dealing with them is very low. The insurance company then holds a bond. however instead of issuing the product as a bond (although they often do call it a bond) it is issued in the form of a life insurance contract. 2. these funds are engineered by buying the derivatives which give the specific payoff. Large fund management companies also sell “structured funds” which are investment funds which have a defined payoff on a specific future date. some asset management companies. they will get back something if they die during the policy lifetime. they will invariably get several competing quotes from rival derivative houses which makes it difficult to make large profits from them. and legally binding commitments from product providers to offer secondary market liquidity with defined bid-offer spreads. the products that they sell have to be manufactured to a high standard in terms of things like being listed on stock exchanges. not manufactured products. having the documentation produced to certain standards. and insurance companies are the easiest to service. This situation occasionally results in confusion when talking about “institutional” business. they are highly competitive and although they will deal in large size. as a hedge for the liability of the insurance contract. they will offfer Commerzbank manufactured products to their wealthiest clients. who do not manufacture products themselves. However. when assembling such a product. and many types of client / investor. In return. Moving up the wealth chain. as they only want to trade derivatives. They simply offer a network of sales people. which is why it is a life insurance contract. these are almost invariably bought as investment products). often including marketing material and other things. and administration systems. custodians etc. They need to have a product which is in a suitable form to be sold directly to retail investors. They may also need the ability to execute small trades (for a few thousand euros) efficiently and quickly. because they sell “finished” products. the contract buyer will get back an amount when the policy matures which is linked to equity performance over the policy lifetime. However. In this case it is important to identify exactly who the end-investor is going to be.Derivatives Insurance companies also do this. (Additionally. etc.3 Summary There are many types of structured product. and they may trade equity derivatives directly to hedge. The contract buyer pays a regular premuim to the insurance company. as a consequence of this. However this is not a significant element of the product. They will hedge equity retail products which they manufacture themselves. As mentioned above. The product manufacturer has to take account of the fees paid for fund admnistration. or a derivative. but who can be serviced much more easily than retail brokers because HNWI can be sold products with very much less regulation than retail investors. which enable product manufacturers to sell their products directly to the public without actually having to deal with the public. The retail market is also serviced by brokers and financial advisers.

Institutional investors who manage assets professionally (who in some cases are the same companies as the intermediaries mentioned above) 14 . both directly and indirectly. sometimes known as the “retail hedge” business. • • • • Retail investors directly through Commerzbank braches Retail and HNW investors indirectly via intermediaries who sell Commerzbank products Retail investors indirectly via intermediaries who sell their own products which are manufactured partly from derivatives which they buy from Commerzbank.Derivatives Commerzbank sells these to various classes of investor.

A call is a buying option. it gives the holder (the person who bought the option for an amount X2) the right but not the obligation to sell the asset underlying the option at a given price. r ) The semicolons are used here to distinguish between different types of parameters: underlying-dependent parameters. which are more complex from a valuation point of view. The second ones can be changed at our discretion in order to fulfill the investor’s needs. Let’s define the value of a general option (Vanilla or exotic) with the symbol V. Their value is usually a function of various parameters. it gives the holder (the person who bought the option for an amount X1) the right but not the obligation to buy the asset underlying the option at a given price. product-dependent parameters and market-dependent parameters.Derivatives 3 Derivatives The word Derivatives is a general term describing investment products. A put is a selling option. μ ). 3. The last ones can’t be modified since they are implied market parameters. The parameters are defined like follows: S: the spot of the asset σ: the volatility of the asset μ: the drift of the asset K: the strike of the option T: the maturity of the option r: interest rates The payout of a vanilla call at maturity T is: Max (0. then the following relation is true: V (t ) = V ( S (t . σ . We therefore deduce that the concept of volatility is fundamental when dealing with these products. meaning that if the value of the asset increases by a given amount. Its graphical representation is: 15 . There is therefore some form of convexity which depends on the volatility of the underlying (this can be seen by analyzing Jensen’s inequality).1 Vanilla options The most common options are named calls and puts. The relationship Asset – Derivative is rarely linear. K . which derive their payoff – therefore called Derivatives . the value of the derivative doesn’t vary by the same amount. T . S T − K ) Where St is the value of the underlying on maturity date and K is the prefixed strike level.from an underlying asset. The underlying dependent parameters can’t be modified (unless we replace the underlying with another one) because they are part of the asset and define its behavior over time. They are therefore defined as being vanilla options to express their simplicity compared to exotic options.

put holders in their decrease.1 YYYYYYYYYYYYYYYYYYYYYYYYY The payout of a vanilla put at maturity T is: Max (0. whereas the maximum gain a put holder can make is equivalent to the strike value. these options always have a non-negative value for their holders.2 YYYYYYYYYYYYYYYYYYYYYYYYY As can be seen on the graphs and in the formulation of the payouts.Derivatives Payoff K S Diagram 2. Call holders believe in the increase of the underlying prices. K − S T ) And its graphical representation is: Payoff S K Diagram 2. It is important to notice that the maximum gain a call holder can make is unlimited. 16 .

There are 4 types of barrier calls and 4 types of barrier puts: Call option European/American UP & IN UP & OUT DOWN & IN DOWN & OUT Put option European/American UP & IN UP & OUT DOWN & IN DOWN & OUT Diagram 2.2 Barrier options Very common options are the time-dependent versions of vanilla calls and vanilla puts. The following graph illustrates the product payoff: 17 . The following graph shows the payoff of the Up & Out call.Derivatives 3. Its payoff is the same as that of a vanilla call. These products are built with barriers that can be touched by the underlying asset at any time during their lifetime.3 YYYYYYYYYYYYYYYYYYYYYYYYY To illustrate these barrier options.4 YYYYYYYYYYYYYYYYYYYYYYYYY Let’s now consider a Down & In put with strike K and with barrier B. Payoff S K B Diagram 2. and the barrier can be above or below the strike level. we will consider the example of an Up & Out call with strike K and barrier B. but the payment is conditioned by the fact the underlying asset has never traded at or above its barrier level during the lifetime of the product. The product can either activated or deactivated when the barrier is touched. The put will be activated if the underlying asset trades at or below the barrier level B. The payoff formula of this put is the same as that of the vanilla put.

Lets consider. Payoff S B K Diagram 2. Thre are various ways to combine vanilla products and the aim of this chapter is to explain the basic principle behind them. strike K.6 YYYYYYYYYYYYYYYYYYYYYYYYY 18 . with barrier at B.3 Combining vanilla products Several investment products.Derivatives Payoff S B K Diagram 2. which at a first glance might seem to be exotic.5 YYYYYYYYYYYYYYYYYYYYYYYYY 3. are effectively composed of vanilla options and are therefore vanilla themselves. Diagram XX shows these two basic structures in dotted lines and their sum in blue. a zero strike call (a call with a strike equal to zero) and a put D & O. for example.

4 Put / Call parity There is a very important relationship in finance known as Put / Call parity. 19 . he is long a call strike K with expiry T 3. the value of the portfolio is therefore: Π T = K + CT − PT It is easy to see that the portfolio position corresponds to the value of the underlying asset at time T.Derivatives 3. The investor has the following positions in his portfolio Π: 1. we get: Π 0 = PV (Π T ) = PV ( K ) + C0 − P0 = S 0 And therefore: PV ( K ) + C0 = S 0 + P0 This last relation is called the Put / Call parity. First we consider the long / short position of an investor at time T and we then discount the portfolio with the risk free rate in order to get the actualized value of the portfolio which will express the Put / Call parity. a put option. he is long a cash position K 2. We will deduce the Put / Call parity in two steps. the underlying asset and a cash position. and therefore: Π T = ST If we calculate the present value of the portfolio Π at time 0. he is short a put strike K with expiry T At time T. It establishes a linear relationship between the value of a call option.

g.Derivatives 4 Black-Scholes Model The Black-Scholes model (BS) is the central in model finance theory. t )dW 4. All securities are perfectly divisible (e. It is possible to borrow and lend cash at a constant risk-free interest rate. t ) = μS and b( X . There are no transaction costs or taxes. which can be written as dX = a( X .1 Stochastic Differential Equations (SDEs) The basic form of a stochastic differential equation for a process X is composed of two parts: the Newtonian term (the deterministic term) and the Brownian term (the random or stochastic term).3 The assumption for the Black-Scholes model The key assumptions of the Black–Scholes model are: • • • • • • • The price return of the underlying asset follows a lognormal distribution with constant drift μ and constant volatility σ It is possible to short sell the underlying stock. There are no arbitrage opportunities. It still remains the most widely used model and represents the starting point for more complex and complete models such as the Local Volatility Model (LVM). 20 . t )dt + b( X . t ) = σS 4. 4. Trading in the stock is continuous. It can usually be written in the following form dX = __ dt + __ dW In finance we find SDE in the form of an Ito process.2 Lognormal returns for asset prices It can be shown that asset returns are lognormally distributed and the Ito process assumes therefore the form: dS = μdt + σdWt S Where a ( X . it is possible to buy 1/100th of a share).

21 .Derivatives 4. option written on the asset S with strike K. 4.5 Black-Scholes closed formulas It can be shown from the Black-Scholes equation that the price of a call.4 The Black-Scholes equation The Black-Scholes equation can be seen as a diffusion-convection-absorption equation. expiry T. and the price of a put option. T ) = Ke − rT φ (−d 2 ) − Sφ (−d1 ) Where σ2 ⎛S⎞ ⎛ ⎜r + ln⎜ ⎟ + ⎜ 2 ⎝K⎠ ⎝ d1 = σ T And ⎞ ⎟T ⎟ ⎠ d 2 = d1 − σ T Here Φ is the standard normal cumulative distribution function. varies over time. denoted by C. Its evolution can be described by the partial differential equation (PDE) ∂V 1 2 2 ∂ 2V ∂V = σ S + rS − rV 2 ∂t ∂S 2 ∂S It is notable that the equation does not contain μ. denoted by P. the drift of the stock. written on the asset S. It determines how the price of a derivative. T ) = Sφ (d1 ) − Ke − rT φ (d 2 ) P ( S . volatility σ and interest rates r can be expressed by means of the following closed formula: C ( S .

22 . Let’s consider the lognormal distributes process previously described: dS = μdt + σdWt S If we don’t take into account the Brownian term. The forward is the expected value of the underlying at a point in the future. is: S (T ) = S 0 e μT = S 0 e ( r − q )T Or expressed as a percentage of the initial spot S0 F% (T ) = S (T ) = e ( r − q )T S0 We see that the forward increases as interest rates increases and decreases as dividends increases. Here we will explain how to evaluate the forward and how it varies over time.Derivatives 5 The Forward A very important concept when pricing an exotic product is the forward of an asset. where the initial condition is given by S0 for t=0. This is a very important observation that will be very useful when we’ll have to deal with the optimization problem. this equation can be rewritten as: dS = μdt S And the solution of this simple first order differential equation.

.. meaning that for each up movement of X. Notice that the correlation is not telling us anything about the size of the individual movements. In other words a correlation ρ between a random variable X and a random variable Y indicates the “probability” of X changing in a given direction and in which direction for a given change in Y. Notice that the correlation ρ is not telling us anything about the intensity of the changes. which expresses the intensity and the direction of their linear relationship. . defined by the two vectors X = [x1. 6. with mean μX and μY and standard deviation σX and σY is: ρ= cov( X . It is important to notice that the correlation is a static value.1 How to calculate historical correlation Let’s consider a time series of N elements on two normal distributed processes X and Y. Definition: The correlation can be seen as a strength vector between X and Y. It can be shown (Cauchy-Schwarz inequality corollary) that the maximum value that the correlation can assume is 1. …. Y ) σ XσY = E (( X − μ X )(Y − μY )) σ Xσ Y = E ( XY ) − E ( X ) E (Y ) E ( X 2 ) − E 2 ( X ) E (Y 2 ) − E 2 (Y ) Where E is the expected value of the variable and cov is its covariance. x3. y2. in order for the correlation to have a mathematical sense the standard deviations have to be different from zero. then the historical correlation can be estimated as: ρ= N ∑ xi yi − ∑ xi ∑ yi i =1 i =1 i =1 N N N ⎛ N ⎞ N ∑ xi − ⎜ ∑ xi ⎟ i =1 ⎝ i =1 ⎠ N 2 2 ⎛ N ⎞ N ∑ y i − ⎜ ∑ yi ⎟ i =1 ⎝ i =1 ⎠ N 2 2 23 . y3. The general definition of the correlation ρ between two random variables X and Y. since this is expressed by the volatility. σX2 = E(X2) − E2(X) and likewise for Y.Derivatives 6 Correlation The concept of correlation is widely used in finance and statistics to indicate the linear relationship between two random variables or between two time series. Y moves up as well and vice versa. meaning that it doesn’t tell us anything about the future variation of the relationship. xN] and Y = [y1. yN]. Since μX = E(X). x2..

that two assets which have a given correlation today might evolve more or less correlated in the future.3 Correlation term structure and correlation skew As we have seen previously.t = wi .t ∑∑ w i =1 j >i N i .1 YYYYYYYYYYYYYYYYYYYYYYYYY 24 .Derivatives 6.2 Implied correlation Let’s consider an index I having N members as constituents and a variance σ2. then the implied correlation of the Index I is defined as: ρ I . That is. We know.t w j . 6.tσ j . More specifically. it can be expressed as a function of time t: ρ = ρ (t ) If actual correlation is high compared to historical correlation then it will lower over time resulting in a downward sloping correlation curve.t w j . CORRELATION TERM-STRUCTURE Correlation Historical Correlation Maturity Diagram 5.t ρ ij . In practice we know that correlation has a more complex behaviour and has to be expressed as a function of time and strike.t The implied correlation is an average correlation value that. if it low compared to historical correlation then it will be upward sloping.tσ i . it has been shown that correlation tends to be mean reverting over time.tσ i . as shown in diagramm XXX.tσ j .t = ∑∑ λij .t i =1 j >i N Where λij . if used to calculate the variance of the index I would give the same variance σ2. for example. correlation expresses a linear relationship between two random variables which is constant in time and strikes.

This is true for assets within the same asset class. If assets from different asset classes are taken. K ) 25 . whereas in a bullish market assets move with lower correlation.2 YYYYYYYYYYYYYYYYYYYYYYYYY Similar to the volatility. corelation might behave in a different way. CORRELATION SKEW Correlation Strike Diagram 5.Derivatives Similarly. we can represent correlation as a surface function of time and strike and defined as follows: ρ = ρ (t . This is generally defined as correlation skew and therefore the following equation holds: ρ = ρ (K ) Diagram XX shows how the correlation evolves with different market levels. The correlation is asymptotic to one in a bearish market and to zero in a bulish market. correlation is not constant for different market levels. assets move with a correlation close to one. In a bearish market.

The standard deviation of a random variable X is usually defined as the square root of the variance. where Var ( X ) = E (( X − E ( X )) 2 ) = E ( X 2 ) − ( E ( X )) 2 And therefore σ X = E ( X 2 ) − ( E ( X )) 2 The T-period volatility σT is defined as σT = σ T Therefore the wider the data is spread around the mean the higher will be the volatility. N Days = Example 1 N ⎛ 1 ∑ ⎜ xi − N i =1 ⎝ N ⎞ ∑ xi ⎟ i =1 ⎠ N 2 26 . x3. then the historical volatility can be estimated as: σ hist . x2. defined by the vectors X = [x1. …. 7.Derivatives 7 Volatility and Variance The standard deviation σ of a lognormal distributed variable X refers to the average change of its value from the mean μ. xN] .1 How to calculate historical volatility Let’s consider a time series of N elements in a normally distributed process X.

T + 2∑∑ ρ ij wi w jσ i . w3. 7.Derivatives 7. Y ) And therefore Var ( X + Y ) = Var ( X ) + Var (Y ) + 2 ρ X . in order to get the most accurate evaluation: 1. σΝ].T σ j . It is important to notice that the BS formula is highly dependent on the dividends of the asset used to estimate the price of the option... Inconvenient: the liquidity of options is usually limited to a few years. wN] and implied Tperiod volatility given by σ = [σ1.3 Basket volatility Let’s consider two random variables X and Y with variance σX2 and σY2. Forecast future dividends form more recent dividends Inconvenient: this methodology is risky in the sense that past dividends not necessarily imply the same amount in the future 3.2 Implied volatility The implied volatility is the market view on the future volatility of a given asset. 2. In other words we observe at which price options are trading in the market and we calculate the volatility that has to be used in the BS formula in order to match that price.Y Var ( X )Var (Y ) 7. X + Y ) = Var ( X ) + Var (Y ) + 2Cov( X . for long term dividends alternatives estimates have therefore to be used. σ2. To calculate the implied volatility we use the inverse form of the Black-Scholes formula. are taxed by 20% on the dividends of US companies. . It is therefore important to take this effect into account when dealing with foreign shares. The volatility of the basket for maturity T is given by: σ B . There are several ways to estimate dividends and the following is a non exhaustive list of methodologies used by traders.T i =1 j >i N −1 27 . The variance σ2X+Y of the combined process X+Y is defined as: Var ( X + Y ) = Cov( X + Y . Calculate the implied dividends form a synthetic forward (call minus put). for example. σ3.T = ∑ wi2σ i2.4 How to calculate the volatility of a basket Let’s consider N assets of a basket B with weights W = [w1. …. European banks. Rely on analysts forecasts Inconvenient: the analysts view can be wrong and therefore the estimate bring to losses Another important point is represented by the taxable amount on the dividends. w2.

usually. 7.1 YYYYYYYYYYYYYYYYYYYYYYYYY This means that. If we draw the implied volatilities calculated via the Black-Scholes model from options written on the same underlying but with different expiries. If we plot the log-returns of the equity market we can see that they slightly deviate from a lognormal distribution. The distribution shows signs of leptokurtosis (or fat tails). This can be explained if we think of the risk associated to longer maturities compared to shorter maturities.6 Skew / Smile Skew (or smile) is a phenomenon which describes the non constant nature of volatility with respect to the strike level.Derivatives 7. VOLATILITY SKEW Implied volatility VOLATILITY SMILE Implied volatility Strike Strike Diagram 6.2 YYYYYYYYYYYYYYYYYYYYYYYYY 28 . we generally obtain an upwards sloping curve like shown in diagram XXX. VOLATILITY TERM-STRUCTURE Implied volatility Maturity Diagram 6. the market quotes longer term options with a higher volatility than shorter term options. particularly on the downside in stock returns.5 Volatility term structure The volatility term structure describes the non-constant nature of the volatility with respect to time.

if equity increases. First. its debt and consequently risk and volatility will increase. Equity Asset = Equity + Debt Debt Diagram 6. with at-the-money volatility in the middle and in-the-money volatilities gently rising on either side (smile) or only on the downside (skew) There are various explanations for why volatilities exhibit skew. On the other hand. This argument shows that we can expect the volatility of equity to be a decreasing function of price. We know that a firm’s value is the sum of its debt and its equity. 29 .Derivatives This has important repercussions on option prices. This value is relatively constant over time and thus if the firm’s equity declines.3 YYYYYYYYYYYYYYYYYYYYYYYYY Another explanation refers to behavior of equity in market crashes. debt will decrease along with risk and volatility. When implied volatilities for options with the same expiry are plotted. therefore. let’s consider a firm. In a bearish market investors suffer from fears of large losses and. In a bullish market on the other hand investors are confident and tend to hold for longer time their equity position reducing therefore the trading activity. Options with different strikes and different expiries tend to trade at different implied volatilities. the graph looks like a smile (or a skew). increase their trading activity.

In case the yen weakened against the euro. 30 .Derivatives 8 Quanto and Compo Options Investors reserve their main interests for “domestic” investments. the investor would have incurred in a loss. The risk associated with the exchange rate at maturity. 2. investors are willing to spread the risk in their portfolio over different countries. European investor (€ domestic Ccy) € 100 FXini ¥ XX Buy a J-stock Sell the J-stock € ZZ FXfin ¥ YY Japanese Market (¥ foreign Ccy) Diagram 7. buy foreign equity and. convert the gain (or loss) back at an unknown exchange rate (which could have risen or fallen). therefore. In case the equity performed negatively (any other parameter remaining the same).1 YYYYYYYYYYYYYYYYYYYYYYYYY It is easy to see that the investor incurs two different risks: 1. convert its euro notional into the foreign currency. Derivatives where the payoff (expressed in foreign currency) is converted back into the domestic currency with the exchange rate at maturity and discounted with the domestic discount factor are called compo options or compo derivatives. If investing in derivatives the situation is even more complicated since the payoff should be discounted at the domestic interest rates. the investor would have incurred in a loss. more risky foreign equity. at the end of the investment. meaning that you need more yen in order to buy euros (any other parameter remaining the same). in fact. like the United States and Japan. Nevertheless a direct investment in US or Japanese equity would not only have an associated Equity-risk but also an implied FX-risk. In other words they prefer to invest in known domestic equity instead of less known and. The risk associated with the equity performance between the buying and the selling date of the J-stock. Diagram XXX shows the cashflows involved in a foreign equity investment. For diversification reasons. A European investor should. Some of these countries can’t even be considered as “risky” since their economy has shown a big stability over the past decade.

the exchange rate follows a lognormal distributed stochastic process: dFX t = (rd − r f )dt + σ FX dWFX FX t Where σFX is the volatility of the foreign exchange and dWFX is the Wiener process. This problem can be overturned by selling to the bank the embedded foreign exchange risk and conserving only the equity risk. These kinds of options are called quanto options or quanto derivatives. where the dividends have to be replaced by: d’ = rf + d + ρ σS σFX and the forward can. Let FXt be the exchange rate at time t. it is easy to see that quanto options have to satisfy a similar equation to the Black-Scholes one. As we know. Here the final payoff is first discounted using the foreign discount factor and is then converted into the domestic currency using a fixed exchange rate. an amount of foreign currency and a given amount of shares: Π = V(FX. t) – ΔFX FX – ΔS S FX Where ΔFX FX is the Euro amount of the Yen amount being short and ΔS S FX is the Euro amount of the shares being short. therefore be rewritten as S (T ) = S 0 e μT = S 0 e ( rd − d ')T = S 0 e Or expressed as a percentage of the initial spot S0 ( rd − r f − d − ρ ⋅σ FX ⋅σ S )T F% (T ) = S (T ) ( r − r − d − ρ ⋅σ FX ⋅σ S )T =e d f S0 31 . Let’s define rd and rf as the riskless domestic and foreign interest rates. S. It is possible to construct a portfolio Π with the quanto derivative.Derivatives Not all the investors are ready to take the FX-risk associated with compo derivatives. The pricing of quanto options is relatively simple and requires the forward to be redefined. The equity price follows the similar stochastic process: dS t = (r f − d )dt + σ S dWS St Where σS is the volatility of the stock price and dWS is the Wiener process. By repeating the same procedure as shown in the chapter 3. which corresponds to the domestic currency amount for one unit of foreign currency.

Derivatives 9 The Greeks • The delta measures sensitivity of the option price V to spot price S. The speed measures third order sensitivity of the option price V to spot price S. 32 . ρ= • ∂V ∂r . vanna = ∂ 2V ∂S ∂σ . which can also be interpreted as the sensitivity of delta to a unit change in volatility. The theta measures sensitivity of the option price V to the passage of time. ∂ 2V volga = ∂σ 2 . The vega gamma or volga or convexity measures second order sensitivity of the option price V to implied volatility σ. Δ= • ∂V ∂S The gamma measures second order sensitivity of the option price V to spot price S. vega = • ∂V ∂σ . The rho measures sensitivity of the option price V to the applicable interest rate r. • The vega measures sensitivity of the option price V to volatility σ. With T the amount of time to expiry: θ =− • ∂V ∂T . ∂ 3V speed = 3 ∂S . • The vanna measures cross-sensitivity of option value with respect to change in underlying level and the underlying volatility. Γ= • ∂ 2V ∂S 2 .

Derivatives • The sensitivity to the skew is also considered like a greek: skew = slope ⋅ 110 − slope Where slope = σ 105% − σ 95% 10% is the curvature of the volatility smile. In general. ∂V ΔV V X 2 − V X1 ≈ = ∂X ΔX X 2 − X1 33 . The underlined greeks are the most important for a structuring position. we define a GreekX as the sensitivity of the option price V with respect to the parameter X: Greek X = ∂V ∂X We always approximate the derivative by a small variation: Greek X = where X 2 − X 1 is small.

Derivatives 10 The Hedge 34 .

it corresponds therefore to the payout of the same option but with expiry t.Derivatives 11 Sensitivities of Exotic Options The aim of this chapter is to evaluate the sensitivities of vanilla options with respect to market parameters. 11.B.0 ⎟ ⎟ ⎜S ⎠ ⎝ 0 In any previous instant t the value of a call option can be decomposed into two components: 1. Pragmatic approach: we can proceed in a more practical (and efficient) way by estimating how the probabilities for being more in the money (respectively out of the money) are going to change. Its time value θt The intrinsic value It is the value the option would have if exercised at time t. The Intrinsic – Time value relationship for a call C at time t expresses the value of the option at that time and can be written as: ⎞ ⎛S C t = I t + θ t = max⎜ t − K . The time value θt is the value that takes into account the probability for the call option to be in the money at maturity T. Mathematical approach: we can differentiate the option with respect to the parameter we would like to analyze and therefore evaluate the impact on the price for a small change in that parameter from its actual value 2.0 ⎟ + θ(t ) ⎟ ⎜S ⎠ ⎝ 0 Diagram XX schematises the Intrinsic – Time value relationship 35 . There are two ways to do this: 1. The two methodologies are not exclusive and crosschecks should always been done in order to minimize errors in the pricing stage. We know that at maturity T. N.1 The Intrinsic – Time Value Relationship We’ll start by considering an at the money (ATM) European call option with strike K and expiry T. The intrinsic value It 2. the value of the call option is equal to its payout (the dark line in diagram XX): ⎞ ⎛S C(T ) = max⎜ T − K .

Higher volatility and longer maturity have both a positive effect on the time value for an ATM European option since the probability for being in the money at expiration increases. The time value on the other side is a function of time and of the volatility. for vanilla options. whereas the opposite effect is observed if dividends increase. 4. 3.1 YYYYYYYYYYYYYYYYYYYYYYYYY Generally speaking we can say that.2 The pragmatic approach to estimate sensitivities Based on the previous discussion we can now analyze the sensitivities of an ATM European call option to different market parameters such as: 1. interest rates dividends volatility strike maturity The intrinsic value is directly proportional to the forward and therefore as interest rates increase the intrinsic value tends to increase. 36 . On the other hand the intrinsic value will increase if the strike decreases since the option would be in the money already since its issue. 2. In case of a vanilla call it grows asymptotically to volatility multiplied by square root of time. 5. the intrinsic value is directly a function of the forward and therefore will be sensitive to interest rates and dividends and of the strike of the option. 11.Derivatives Price θt It K S Diagram 10.

37 . Definition: Counterparty A is said to be long (respectively short) a derivative or a generic market parameter Y if the increase of Y. Y in the previous example was a call option but could in effect also be a market parameter such as volatility. A long position is therefore associated with buying Y and a short position is associated with selling Y.Derivatives 12 Being long / short Short and long are general terms used in finance to specify what the position of an investor or a trader is with respect to a market parameter X if a derivative Y is exchanged between the two parties. Let’s suppose that an investor A buys a call option Y from a bank B as shown in the diagram below. B is then said to be short Y and A is said to be long Y. correlation etc. A is said to be short dividends since the increase in dividends would decrease the intrinsic value of the call option. Analyzing further. represents a gain (respectively a loss) for A. In the case of the call for example we said that A bought the call and is therefore long the option. It is common in finance to switch from one definition to the other: buying Y or being long Y are therefore completely equivalent and are used indistinctively. at any time t after he first established his long (respectively short) position at time 0. skew. A is said also to be long vega since an increase in volatility during the lifetime would increase the time value of the derivative itself.1 YYYYYYYYYYYYYYYYYYYYYYYYY The terms are used even in a more general and wider sense. dividends. A Y(t) Y(0) B time Diagram 11.

which corresponds to Libor minus a small fixed amount X called funding.Derivatives 13 Swaps. at prefixed intervals to counterparty A. notes and certificates.1 Swaps A T-year swap is a derivative contract written between two counterparties where they agree to swap a stream of cash flows at prefixed dates in the future expiring at time T. Notes and Certificates There are different ways a bank can issue a derivative instrument to its clients. Diagram XX shows the basic structure of an equity swap.2 Equity-linked swaps If we replace the fixed leg stream of a swap with an option we obtain an equity swap. The simplest form of swap is the interest rate swap where the counterparties agree to exchange a fixed against a floating amount. A option Libori .1 YYYYYYYYYYYYYYYYYYYYYYYYY Counterparty B pays a floating amount. 13. The floating amount is usually linked to Libor (London Inter Bank Offer Rate). The total amount received from counterparty A is therefore time ∑ ( Libor − X ) i =1 i i N 38 . The most well known are of three types: swaps.X B T Diagram 12. 13.

3 Bonds Bonds are special financial instruments which are used to raise capital. The bond issuer has then the obligation to pay back its debt at maturity T by repaying the principal amount. The simplest form of bond doesn’t pay any coupon during its lifetime and is called a zero coupon bond. A capital protected note ensures the investor to receive back at maturity at least the amount initially invested (this is of course less than what he could have done by earning interest on the same amount). 13. evaluated with the current levels of interest rates. Bond option X X B T time Diagram 12. This means that ∑ ( Libor − X ) = Option + M arg in i =1 i i N Bank 13. in order for the payment to be consistent the value of the floating amount leg has to be equal to the value of the equity option (plus the sales margin if any). We know that in order to have X at maturity T we need to 39 . Notes are simply the combination of a zero coupon bond plus an equity option as shown in Diagram XX. It is a debt instrument with maturity T issued by a company or by governments in exchange of a principal amount.2 YYYYYYYYYYYYYYYYYYYYYYYYY If counterparty B wishes to invest an amount X into a 100% capital protected note then he would pay X to counterparty A. It is easy to understand that the value of a bond varies over time since its value is linked to interest rates.4 Equity Notes In the derivative world bonds are used to construct specific products which are called capital guaranteed notes.Derivatives Counterparty A on the other hand pays the equity option to counterparty B at maturity T. The value of a zero coupon bond which pays X at maturity T is worth today the net present value of X.

e. The remaining amount (i. the difference between A and its net present value) is then used to buy an equity option with maturity T plus the margin for counterparty A (and the margin for counterparty B if it will be sold further to a third party). The following equality has therefore to be satisfied: ZCBond + Option + M arg inBank + M arg inClient = 100% 40 .Derivatives invest the net present value of X into the money market. earning interest on it.

For vanilla products most of the second order effects can be neglected and therefore a simple model (for example the B-S model) is good enough in order to get a reliable price. 41 . 14. A more “exotic” model has. therefore. There are cases when second order effects cannot be neglected because they have a significant impact on the price of the option. As previously discussed. The word “fairly” means that the model has to be able to correctly price securities which are available in the market. In other words if we evaluate first derivatives with respect to a given parameter. Why are there different models in finance? 2. In addition to this. has to be able to correctly evaluate vanilla options on the individual shares. two basic questions to which we should try to give an answer: 1. which is different from the B-S model. This model. Before pricing a derivative we have therefore to analyze which effects have to be taken into account and which one be neglected and this decides the model which has to be used in order to correctly evaluate the price of an option. A model could generally be defined as follows: Definition of model A model is a series of laws which have been derived from empirical observations and which have to describe and predict a given process in the best possible way. We have seen that this is not exactly the case since in the market we observe a skewed behavior of lognormal returns.1 The calibration process The calibration proces of a model is crucial in order to fairly evaluate a derivative. this will generally be different from zero.Derivatives 14 What are Models There are various models that can be and have to be used in finance to price derivatives. at this point. it has to correctly price fixed income securities such as bonds. Skew doesn’t affect ATM European option and they can be therefore correctly priced with the B-S model. Let’s give an example to better understand this concept. like in physics. giving exactly the same price as the B-S model. The process of “adapting” the parameters of the model in order to get the same price as the B-S model is called the “calibration process”. a model where the skew is correctly modeled is necessary. different models have been developed depending on the complexity of the derivative which has to be analyzed. Options are characterized by a non-linear behavior. This product can’t be priced with the B-S model because the skew has a significant impact on the price. This is not the case when dealing with OTM or ITM options. There are. in the B-S model the volatility of the underlying option is considered to be constant. When pricing options one has to take into account the effects of the non-linearity. Suppose that we need to price an exotic barrier option linked on a basket of two shares. How can we choose the right model when pricing derivatives? In finance. to be used. They can vary from very simple Black-Scholes model to more complex (and complete ones) such as the local volatility model and the stochastic volatility models.

So what is the fair price to agree to buy / sell the share in the future. you no longer care about its price in the market.2 How all derivative pricing models actually work All derivative pricing models have at their heart one very important principle: that the price of a derivative is the cost of removing the risk of having sold (or bought) the derivative in the first place. The price at which the share will be traded in the future is agreed so that there is no initial value to the contract i.1 YYYYYYYYYYYYYYYYYYYYYYYYY 14. The Black and Scholes approach assumes that the way to remove the risk is to trade the share underlying the option. Once you have bought the thing. Consider a very simple derivative – a forward. What can the seller to do remove the risk? If you know for absolute certain that somebody will come and buy a specific thing from you for a known price on some defined date in the future. However this is not the full cost of the strategy. This contract is simply an agreement for two counterparties to trade a share on a future date at a price to be agreed on the deal date. Then there is no more risk. So if you have entered into a forward contract where you have to sell a share. 42 . and neither can walk away from the deal once it has been struck. where the buyer can abandon the contract with no penalties. no money need change hands up-front in order to make the contract “fair”. so that no money need change hands up-front as part of the contract? The hedging strategy is to buy the share. The price that one gets from the Black and Scholes equation is simply the cost of running a trading strategy that will replicate the derivative payoff. which will have at any time a known market price. Both counterparties are obliged to trade the share. i. the obvious strategy is to own the thing now. The share has to be “financed”. the obvious hedge is to buy the share as soon as possible.e.e.Derivatives B-S Model Exotic option OK X OK OK OK Vanilla option on share A and on share B Exotic option on a basket of shares A + B Diagram 13. the money has to be found to buy the share. So it is not like an option. and the outcome is known with certainty.

The seller. An important point about the hedging strategy in the simple world model. The total cost of the hedging strategy is therefore the cost of the share. So the seller needs to do something else. It is not necessary for the seller to know in advance whether it is more likely that the share go up or down – they are completely indifferent to the final price of the share. One possible strategy would be to sell the share immediately should the price fall below the strike price of the contract. which is the current price of the share. Consider a very simple world where it is known that the share price is either going to be 90 EUR or 110 EUR at maturity. So if they charge 5 EUR up front for the option. at a price of 55 EUR. and a more complicated model of the world is needed to accurately cover the possible outcomes. The fair price to sell the share in 1 year will be 105 EUR. on the deal date. things are clearly a little more complicated and the above model is inadequate. So the fair value of the option in this very simple model universe is 5 EUR. worth 45 EUR. and buys the share. In the real world. because the buyer would be better off buying the share in the market. assume that interest rates are zero. some money will need to change hands up front to compensate one counterparty or the other. in simple terms. At expiration. and buying or selling another half share at some point in the future depending on the way in which the price moves. So their position at the end of the contract is economically identical to their position at the start. plus the cost of borrowing the money to buy the share. As an example. If the share price drops. irrespective of any changes in the price of the share. leaving the seller holding a share which is worth less than 105 EUR. This. so they will lose 5 EUR in this case. So they will abandon their side of the contract. The important thing here is that the forward price of the share is not defined using some arbitrary formula. the seller of the option is left holding half a share. plus the cost of borrowing 100 EUR for 1 year. They will.Derivatives Let’s assume that this money has to be borrowed. assuming that it is about equally likely that the share is going to go up as down. borrows 100 EUR. There is a cost to this borrowing equal to the interest rate paid. and what all models are about. and buy it again as soon as the price goes above the strike price. To further simplify the analysis in this case. for a loss of 5 EUR. if the price is 110 EUR. the situation is different. but with a loan of 105 EUR to repay. When it comes to a contract where the party who is buying the share can walk away from the deal with no penalty. The critical point here is that the seller loses 5 EUR in both cases. So the seller can do nothing other than sell the half-share. In reality a much wider range of outcomes is possible. This is what actually costs money and why the premium for an option is not zero. and will need to buy another half share. assume that the share price is 100 EUR. The formula comes from somewhere – it is the cost of removing the risk on the contract. The strike price of the option is 100 EUR. and pay back the borrowing which will have grown to 105 EUR. If the agreed price for the trade in the future (commonly known as the “strike”price) is different to 105 EUR. they sell the share for 105 EUR. the seller will hold half a share worth 55 EUR for which they paid 50 EUR. by buying half a share initially. The buyer is not interested in the option because they can buy the share more cheaply in the market than they can from the option seller. The simple strategy described above will not work in the case that the share price is below 105 EUR on the expiry date. for which they paid 50 EUR. In 1 year. is that it involves buying shares at a higher price than they are sold. The seller of the contract buys half a share on the deal date. they will break even under all possible scenarios. is what all derivative hedging is about. and the interest rate is 5%. The total cost for the seller was 105 EUR. given a model of how share prices move 43 . Another would be to “smooth” the trading. and deliver the lot to the counterparty for a total price of 100 EUR. between the deal inception date and the date on which the share is going to be sold. the term of the contract is 1 year.

basic derivative pricing assumes that the price of the underlying jumps around continuously. and then adds up the effect of these very short term moves. it calculates the option payoff that would result. will result in an exact outcome for the hedger i. as it moves up. tell you how much you will lose from this process of buying high and selling low. This is why vanilla option prices are linked to volatility. Therefore the distribution of returns over time is not log-normal either. the hedger is entirely indifferent to the performance of the share during the option’s lifetime. and the model describes the way that the price moves in the very short term. to avoid having to simulate the entire path followed by a share price during the lifetime of the option.Derivatives about in the short term. the losses that result from the buy high / sell low strategy are larger than they will be for a less volatile share. It simulates a number of single jumps from start to option expiration. For each simulated jump. when observed over some long time period (remember that the “model” of the stock price only describes what happens in the very short term). and also that it incorporates a hedging strategy that. and by large amounts. of the payoff of the option at each price. Another important point is that the hedger does not care whether the price of the share goes up or down. one observes skew and smile. Remember that the Black and Scholes model of a share price only describes how the price varies over short periods of time. by calculating the loss that results from following the hedging strategy over the lifetime of the option. Black and Scholes option pricing is therefore just a complicated way of working out the loss from running a hedging strategy like the one described above. The model makes assumptions about how the share price behaves in the very short term. As described above. to calculate the losses that result. This standard model leads to the well-known lognormal distribution of returns. so that the distribution of the prices at the end of the jump is the same as the distribution of prices that would result if the share price followed the exact short-term process described in the Black and Scholes equation. The Black and Scholes breakthrough was that it represented a simple model of how the market behaves which is reasonably accurate. However when the Black and Scholes equation is solved. they just care that the model covers the potential outcomes regardless of their probabilities. which systematically buys shares at a higher price than they are sold. the standard Black and Scholes model assumes that the size of the change of the price of the stock is related to two things: the square root of the length of time over which the change is being moved. and there is no time-dependency of the process. The conclusion is that the simple Black and Scholes model of the short-term evolution of the share price is not quite right. given the final distribution of share prices that you get from the short-term model of how the price of the underlying evolves. which is a fixed number. and does not make any predictions about its long term performance. on average. if the market behaves in the way the model describes. The model also assumes that the universe is static. multiplied by the probability of ending up at that price. Approximately speaking. the stock price moves down as often. is the same as the price that you get from calculating the average value of the option.e. using a relatively simple mathematical formula. and by as much. in that the volatility does not change. Another important aspect of the model is that. So the option price that you arrive at. This gives us an alternative way of calculating the price of the option. and the “volatility” of the stock. over the possible prices at maturity. Then the option price is simply the average of all of these simulated payoffs (discounted by the appropriate amount). it is seen that the price of the option is also equal to the sum. Also included in the pricing model is the cost of financing the hedge. combined with the hedging strategy which specifies how many shares are actually being held at any time. Note that calculating this implied distribution does not 44 . We can acalculate what the implied distribution of long-term returns must look like. However when option prices are observed in the market. Monte-carlo simulation uses this fact of option pricing. For shares whose price jumps around a lot.

not splife products) most things cannot be priced with this model. The final price of the option for any given path can be calculated by examining the share price on the two fixing dates. like variance swaps) The model includes a complete volatility surface for each underlying. but suffers from some drawbacks linked to the way it prices path dependent options.e. 14. However. It is simple to price non path-dependent options by simulating returns of the underlying according to the implied distribution of returns at maturity. 45 . but the effect of skew is not taken into account. 14. so black diffusion is not often used.5 Vskew This model takes account of skew. we cannot treat the price of the underlying on the two fixing dates as independent things. Splife products can be priced with Black Diffusion. but no skew.4 Black Diffusion This is the simplest possible model which can be used with Monte-Carlo simulation or finite difference pricing. you can run a Monte-Carlo simulation that takes account of the skew. Note that with a path-dependent option. As described above. If you can work out what the eventual distribution of returns is. compared to the situation where the share price is high on the first fixing date. one whose value at maturity is linked to the price on some intermediate date as well as at expiration. we don’t have to worry about the short-term process. this model takes account of skew by calculating the implied distribution of returns of an option underlying. an option whose value at expiration is linked to the value of the underlying during the lifetime of the option as well as just the value of the underlying at expiration. this approach can lead to difficulties when a path-dependent option is priced (that is. Imagine now that we have an “path-dependent” option. by examining vanilla option prices. for example a barrier option or an asian option). we do not have to worry about what is supposed to be happening to the share price between the start date of the option and the expiry. For many products this effect is quite significant.e. We have to run a Monte-Carlo simulation that uses the correct distribution of returns for both of these fixing dates. but cannot be used in conjunction with either Monte Carlo simulation or finite difference pricing. and can only be used for analytic pricing of vanilla options (and products which are made up of vanilla options. and another jump from the first fixing date to the second fixing date. i. just the eventual distribution of returns. this is not too difficult. If we do this. This is because they are not independent – a large drop in the share price between the start date and the first fixing date makes it likely that the share price will also be relatively low on the second fixing date. We just simulate one jump from the start date to the first fixing date. It has a term-structure of volatility for each underlying.Derivatives actually tell us anything about the short-term process that generates this distribution – there are in fact infintely many short-term processes that could in theory produce the same distribution of returns over the longer term. But for Monte-Carlo simulation. This is possible because we know that the same short-term process governing share prices applies equally over both periods of time. Because it can only be used with analytic pricing (i. In a world with no skew.3 Black Vanilla Black vanilla is the simplest model. The price on the two fixing dates is correlated. 14.

14. However local volatility is a widely used model for pricing many types of option. However.8 Stochastic volatility 46 . it is possible to produce a matrix which is populated with short-term volatilities for each share price and future date. So we know the distribution of returns between today and the first fixing date.Derivatives However. because of the calibration step. one should be able to say. It does this by generating simulated Monte-Carlo paths by taking each jump in turn. long-term jumps cannot be calculated so easily and the model is therefore quite slow. This lead market practitioners to develop models of the share price process where there is a correlation between the share price and the volatility. both spot starting and forward starting. the distribution of returns on each of these dates might be known. but it is a very powerful and widely used model which is the benchmark for most pricing. the overall distribution tends towards a normal distribution. Another way of looking at this is to say that this model assumes that the 1 year skew in 1 year’s time will be exactly the same as the 1 year skew now.6 Pskew Pskew attempts to overcome the problems that Vskew has with pricing forward starting options. it does not give the right price. 14. We do not know anything about the distribution of returns between the two fixing dates. The problem with this model is that when a long-dated vanilla option is priced using this model. 14. for any day in the future and level of share price. Furthermore. and models where the volatility is itself a stochastic process. This leads us to the conclusion that there is no simple process of share prices that can lead to the skew that is observed in the market. So in a local volatility world. but not anything else. and the need to calculate paths with many intermediate points and not just the fixing dates which are needed. as all processes tend to produce the normal distribution in the long-term. that if one takes successive draws from any distribution at all. There are some known problems with the so-called “dynamics” of the implied volatility with this model. By examining vanilla option prices. what the volatility will be on that day. as the volatility for each short-term jump can be calculated easily from the matrix.7 Local Volatility Local volatility is a simple concept which say that the instantaneous volatility of the process which drives share price changes is a fixed function of time and the actual share price. where intermediate points in the path are generated (these points do not impact the pricing directly. These are explained later. but nothing is known about the process followed by the share price in the short-term. as mentioned earlier. according to a distribution that is calculated by assuming that skew stays the same over each jump. So Pskew can be used to price simple cliquet options. and we know the distribution of returns between today and the second fixing date. What one can observe is that the model does not produce enough skew in the long-term. This is a direct result of the Central Limit Theorem. but the fact that they are calculated will influence the distribution of returns on the expiration date of the option). this model leads itself to Monte-Carlo simulation.

A share price can double. The average level of the basic volatility of the share price. and the speed to which the basic volatility reverts to its mean level. The holder of such a position will systematically lose money if implied volatility changes.8. Other types of options. So the total position will no longer be hedged if implied volatility goes up. the convexity cost of the strategy is accounted for in the shape of the volatility surface.1 The Heston model The dynamics of the calibrated Heston model predict that: • • • volatility can reach zero stay at zero for some time or stay extremely low or very high for long periods of time. implied volatiltiy does not increase without limit. It is even possible to construct a portfolio of vanilla options (the “butterfly” strategy”) which has strong convexity. and it is clear that it does. except for very short periods. This is clearly not true. for example simple barrier options.Derivatives Stochastic volatilty attemps to address the “dynamics” problem mentioned in the previous paragraph. 47 . whereas volatility cannot feasibly increase above a certain level. in just the same way that the basic Black and Scholes model calculates the cost of re-heding the delta of an option. The mathematical characteristics of stochastic volatility models are the following: 14. often called “best-of ratchets” or “reverse cliquets” or “napoleons”. (This mean reversion is necessary as it is clear that. and as implied volatility goes up and down. Note that there is a common misconception that it is the forward-starting nature of these options than means they have to be priced with stochastic volatility models. This means that their sensitivity to implied volatility is not constant. If implied volatility then drops. So a positive vega convexity position will consistently make the holder money when implied volatility varies itself. it is the fact that they have strong vega convexity. the correlation between the basic volatility and the “vol of vol”. However with the vanilla options. treble. The hedger will need to sell some more vanilla options in order to have a hedged position again. The problem arises where an exotic option position has negative vega convexity. They will make money on this unwind. and also the problem that local vol assumes that the only thing which causes volatility to change is changes in share prices and the passage of time. the volatility of this volatility. then its sensitivity to implied volatility increases as implied volatility increases. as the exotic option will have become more sensitive. This is not true. as they are buying back the vanilla option at a lower level of implied vol compared to the level at which they bought it. can also have strong vega convexity. So they need a model to calculate the cost of these changes. quadruple or even more.) So stochastic volatility models are used to price options with vega convexity. one can observe that there is a random element to volatility. unlike a share price. the hedger will have to unwind the vanilla option trade. If the exotic option has “positive” convexity of vega. Stochastic volatility models generally have five components. so will the sensitivity to this parameter. This can be very important in pricing certain types of option which have “vega convexity”. Imagine a situation where an exotic option which has a positive sensitivity to implied volatility is vega-hedged with a vanilla option. The classic example of an options with vega convexity are certain types of cliquet option.

2 The Hagan model The dynamics of the Hagan model predict that: • • • the expectation of volatility is constant over time variance of instantaneous volatility grows without limit the most likely value of instantaneous volatility converges to zero.3 The Scott-Chesney model The main drawback of the Scott-Chesney model is that: • • it requires very high correlation between the spot and the volatility process to calibrate to a pronounced skew the skew is fully deterministic These features are also shared by all of the above discussed models. ⎧dS = μSdt + σSdWS ⎪ ⎨ dσ = ασdWσ ⎪ E [dW dW ] = ρdt S σ ⎩ 14.8.8.Derivatives ⎧ dS = μSdt + v SdWS ⎪ ⎨dv = κ (θ − v)dt + α v dWv ⎪ E [dWS dWv ] = ρdt ⎩ 14. ⎧ dS = μSdt + e y SdWS ⎪ ⎨dy = κ (θ − y )dt + αdW y ⎪ E dW dW = ρdt S y ⎩ [ ] 48 .

The vega is a constant line as shown in diagram XX. Price Sigma Diagram XX A call option price function of volatility It is easy to verify that the vega in this case is equal to a constant value. or paid out at each reset date. Forward skew effects Not all cliquets are sensitive to volatility of volatility and forward skew.4 * σ * T If we draw the price of this option with respect to the volatility we can see that it is a straight line with positive slope. it is therefore independent from the level of the volatility. 15.Derivatives 15 Cliquets A cliquet. We’ll see what the impact is on the main types of re-striking options. Volatility of volatility effects (vega convexity) 2. ratchet option or strip of forward start options is a derivative where the strike is reset each observation date at the then current spot level. We have seen that its price can be written as C ≈ 0 . The profit can be accumulated until final maturity. Cliquets are complex exotic products where second order effects can significantly affect the pricing.1 Volga (or Convexity) Let’s consider an ATM European call option. There are two main effects which have to be considered: 1. as shown in Diagram XX. 49 .

Derivatives

Price

Sigma

Diagram XX A call option vega function of volatility

So for an ATM call

Volga =

∂ 2V =0 ∂σ 2

Consequently, vanilla options don’t have price convexity. Some exotic derivatives can have a non zero convexity which needs to be hedged like in the case of cliquets. Let’s suppose that the price a generic derivative follows a parabolic curve like shown in diagram XXX.

Price

Sigma

Diagram XX Exotic option price function of volatility showing convexity

50

Derivatives

The vega is a linear function of volatility and will therefore change sign around a value σ* (like shown in diagram 8) Vega

Sigma

Diagram XX Exotic option vega function of volatility.

As you can see the vega is here not constant with respect to volatility but is a linear function of volatility. We call σ* the volatility where the vega is equal to zero and changes of sign. If we are buying volatility, the more σ increases, the shorter the vega is. In order to hedge our position, we need to buy the volatility, therefore we buy the volatility when it increases and we sell it when it decreases. This hedging cost has therefore to be included in the price of the derivative. Finally when the Volga is non zero, we are dealing with the volatility of the volatility, so we need to consider a stochastic volatility.

15.2

Types of Cliquets

There are various types of cliquets options and an extensive list would not be possible. We’ll present only the main typologies since the effects which have to be taken into account are common to all of them.

15.2.1

Classic cliquet

The classic cliquet is a forward starting option, which fixes its strike at time t (from today) and expires at time T (from today). For a cliquet call option the payoff would be:

⎛ S ⎞ Payoff T = Max⎜ 0, T − 1⎟ ⎜ S ⎟ t ⎝ ⎠

51

Derivatives

15.2.1.1

Cliquet behavior

Let’s consider an ATM forward starting call option. This derivative would pay at time T the performance of the underlying asset over the time T – t if positive, zero otherwise. As we know an ATM call option is not sensitive to skew effect. Similarly a forward starting call option will not exhibit any sensitivity in change in volatility with respect to the strike, meaning that the sensitivity to forward skew is equal to zero. The only parameter that has to been taken into account is the forward starting volatility with maturity T – t. This can be evaluated with the simple variance equality:

**σ 12T1 + σ 12 2T12 = σ 2 2T2
**

and therefore

σ 12 =

σ 2T2 − σ 1T1

T12

Diagram XX shows the legs and the volatility considered in the formulas above. S0 St ST

σ1, T1 σ2, T2 σ1*, T12

σ12, T12

Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. the price of a european ATM call starting at time t with maturity T12 is therefore the same as the one for a european ATM call starting today and with maturity T12 adjusted by the change in volatility (from σ1* to σ12) times the volatility sensitivity (because the vega convexity is equal to zero).

**C (σ 12 , T12 ) = C (σ 1 , T12 ) + Vega * (σ 12 − σ 1 )
**

*

15.2.2

Ratchet

A ratchet option is a strip of forward starting options, which fixes their strikes at time i and are evaluated at time i+1. The performances evaluated are thereafter summed together and paid at maturity T. For a call ratchet option the payoff would be:

N ⎛ S ⎞ Payoff T = ∑ Max⎜ 0, i − 1⎟ ⎜ S ⎟ i =1 i −1 ⎝ ⎠

52

Diagram XX shows how σ12 varies for a 1% increase in σ1 considering that σ2 is not changing.2. The call with expiry T would have as well a positive vega exposure with respect to the volatility σ12. it is in effect vega negative with respect to the volatility corresponding to the previous fixing. To understand this let’s evaluate how the vega position would be at an instant t. This can be evaluated with the simple variance formula: σ 12 = σ 2T2 − σ 1T1 T12 In the case of a ratchet the effect of volatility of volatility has to be taken into account. but this volatility decreases if σ1 increases. being the sum of forward starting cliquets. Let’s consider a strip of two ATM forward starting call options. whereas the second call will tend to decrease if σ1 increases (assuming that σ2 hasn’t changed). This means that at a future instant t the price of the ratchet varies in a non linear way since the first call tends to increase in value if σ1 increases. At an instant t. T12 Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. 53 . As seen before.2.1 Ratchet behavior We have seen that classic cliquets are insensitive to forward starting skew. the call with expiry t1 would have a positive vega exposure with respect to the volatility σ1. T2 σ12. T1 σ2. T1 and T12. between the initial strike date t0 and the first fixing date t1 like shown in Diagram XX. t t0 t1 T time σ1.Derivatives 15. meaning that even if the overall exposure of this call is vega positive. Ratchets are therefore insensitive as well by definition. But there are other interesting effects which have to be analyzed. the only parameter that has to been taken into account is the forward starting volatility between the two fixing date t1 and T. This derivative pays at time T the sum of the positive performance between each subsequent period.

Derivatives

Δσ12

σ1

Diagram XX YYYYYYYYYYYYYYYYYYYYYYYYYY It is easy to understand that the vega is highly sensitive to the evolution of the volatility term structure: change in the volatility of the volatility have therefore to be taken into account. It is important to highlight that in the case of a volatility surface moving all by the same amount, the vega would have shown a linear behavior.

15.2.3

Reverse cliquet

A reverse cliquet can be generally defined as a globally floored option where the payoff depends on locally capped performances. Usually a reverse cliquet has a maximum payout starting at X which decreases as the sum of forward starting put options increases in value. The payoff would therefore be:

N ⎛ ⎛ S ⎞⎞ Payoff = Max⎜ 0, X + ∑ Min⎜ 0, i − 1⎟ ⎟ ⎜ S ⎟⎟ ⎜ i =1 i −1 ⎝ ⎠⎠ ⎝

The reverse cliquet is sensitive to both the volatility of volatility and the forward skew. In the following section we will show why this is the case.

15.2.3.1

Reverse cliquet behavior

Let’s consider how the vega of the reverse cliquet behaves when the volatility varies from small to significant values. If volatility is low the sum of the values of the ATM put options will be very sensitive in volatility changes since a small shift in the surface will be reflected in the change in value of all the single put options and the total vega will therefore be the same as the sum of the individual vegas. If volatility is high, on the other hand, a small change in the volatility surface will not affect the vega since the probability for the puts to be in the money is very high, which in turn is very likely to quickly exceed X. The vega profile can therefore be represented as follows:

54

Derivatives

Vega

Sigma

Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. The reverse cliquet, like several other similar cliquets, can therefore be considered as a put option on volatility as shown in diagram XX. Vega

Sigma

Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. As we know a put option has a positive sensitivity to vega. It is, therefore, easy to see that if we are using a model which doesn’t take into account the volatility of volatility we are in fact pricing a put option without its time value and the price is therefore incorrect. A model which simulates the stochastic behavior of volatility is here needed in order to correctly price the additional optionality. The reverse cliquet is equally sensitive to forward skew, even if its sensitivity is here less important if compared to that of volatility of volatility. To see why this is the case, we’ll analyze * the skew exposure is when we fix the last strike (meaning the fixing before maturity) at time t .

55

Derivatives

t0 time N-1 N

**Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. Let’s suppose that the following relation is valid at time t
**

N −1 ⎛ S ⎞ X ′ = X + ∑ Min⎜ 0, i − 1⎟ ⎜ S ⎟ i =1 i −1 ⎝ ⎠

*

[ZZZ]

The payoff at time t* for the maturity T is therefore:

**⎛ ⎛ S ⎞⎞ Payoff = Max⎜ 0, X ′ + Min⎜ 0, N − 1⎟ ⎟ ⎜ S ⎟⎟ ⎜ N −1 ⎝ ⎠⎠ ⎝
**

This can be seen as being short an ATM call and long a call strike done by 1-X’, both fixing the strike at N-1 and with expiry at N, as shown in figure XXX. Payoff

1-X’

1

S

Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY.

56

To understand this let’s see what the payoff would be at the last strike date (the one before maturity): ⎛ ⎛ S ⎞⎞⎞ ⎛ S Payoff = Max⎜ 0. N −1]⎜ S ⎠⎠⎠ ⎝ i −1 ⎝ N −1 ⎝ We can easily see that the payoff is worth zero if 57 .. is sensitive to volatility of volatility and to forward skew... which results in a call spread. Min ⎜ i − 1⎟ ⎟ ⎟ ⎟⎟⎟ ⎜S ⎜ i =[ 0 . The individual monthly puts will therefore have a given probability to be in the money and the more valuable of them will have a given probability Π1 to assume a value X1. X + Min⎜ i − 1⎟ ⎟ ⎟⎟ ⎜ i ⎜S ⎠⎠ ⎝ i −1 ⎝ The client receives. This means that the volatility won't vary significantly from a given fixed value. In other words. on the other hand. The forward skew has less significant impact if compared to the reverse cliquet. a non-linear function of volatility. 15. in this case again. like the reverse cliquet. The call one is short. The vega is therefore close to zero.2. Let’s now analyze the sensitivity of the Napoleon with respect to the forward skew. which will be greater than Π1.4.2. Let’s consider the case where the volatility of volatility is close to zero.4 Napoleon Let’s now consider a Napoleon with monthly resets. It is easy to see that the call one is long is always in-the-money and this results in a positive sensitivity to skew for this call.1 Napoleon behavior The vega is. The vega profile as a function of volatility is here again similar to the one shown in diagram XXXX.. therefore. If volatility is very high. The total exposure is therefore a positive exposure to skew. X + Min⎜ N − 1. This is not the case if volatility is low. In this case increasing the probability Π will have a significant impact on the options price and this corresponds to a significant vega. If we increase now the volatility of volatility the probability associated to each monthly put will in general be different and the more valuable of them will have a probability Π2 to assume the same a value X. Increasing the probability Π for the put being in the money will have no effect on the price since the payoff has an overall floor at zero. is always at-the-money and is consequently non sensitive to skew. if we consider stochastic volatility the most valuable monthly put will assume higher values compared to the case where there is no volatility of volatility.Derivatives The dotted line shows the total position of the holder of the reverse cliquet at time t*. which pays a yearly coupon expressed by the following formula: ⎛ ⎞⎞ ⎛ S Payoff = Max⎜ 0. small shifts of the volatility surface will in general leave unaffected the price of the Napoleon. a coupon of X plus an amount which corresponds to the smallest monthly return. 15. The Napoleon as well.

Max⎜ Floor . N −1] ⎝ i −1 ⎠ But we have to distinguish two cases: ⎧ ⎛ Si ⎞ ⎪i =[ Min−1]⎜ ⎜ S − 1⎟ > 0 ⎟ ⎪ 0.5..2. N −1] ⎝ i −1 ⎠ And corresponds again to a call spread otherwise. therefore... Since the holder of the option is long the call spread he is effectively buying the call with the lower strike and selling the call with higher strike. This is true since we are taking the smallest return over the period.5 Accumulator ⎛ N ⎛ ⎞⎞⎞ ⎛ S Payoff = Max⎜ 0.2.. The two strikes tend.... to be closer if compared to the reverse cliquet. The lower strike corresponds to SN −1 = −X S N −1 Whereas for the upper strike corresponds to ⎛ S ⎞ Min ⎜ i − 1⎟ ⎜S ⎟ i =[ 0 ..1 Accumulator behavior XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX 58 . The contract is in general long skew where the overall sensitivity is lower than the one of the reverse cliquet since the two strikes lie closer in this case.. The probability that the second condition is verified is higher than the probability associated to the first condition... If the first condition is true then the lower strike is below the ATM and the upper strike is above the ATM..Derivatives ⎛ S ⎞ Min ⎜ i − 1⎟ < X ⎜S ⎟ i =[ 0 .. If the second condition is verified then the two strikes lie below the ATM... ∑ Min⎜ Cap. 15. N ⎝ i −1 ⎠ ⎨ ⎪ Min ⎛ S i − 1⎞ < 0 ⎜ ⎟ ⎟ ⎪i =[ 0. N −1]⎜ S i −1 ⎝ ⎠ ⎩ In the two cases the sensitivity to skew will be different.. i − 1⎟ ⎟ ⎟ ⎟⎟⎟ ⎜ ⎜ ⎜ i =1 S i −1 ⎠⎠⎠ ⎝ ⎝ ⎝ 15.

Derivatives 15.6 Comparing cliquets Table for comparison 59 .2.

The value of the option has therefore not changed (if we neglect the time decay) and the call is still worth X1. Usually their effect is negligible for vanilla options and most of the more common exotic options. has to buy (or sell) that amount of shares. meaning that all the market parameters have remained constant over time. Once these have been hedged. It is possible to categorize the main risks into the following sub-categories: 1. The role of the trader is to ensure that the right amount of risk is always hedged away in order to be able to fulfill the conditions stated in the contract. 4. as stated previously. vega and correlation). Suppose that after a period t. resulting from the products issued. equals zero.Derivatives 16 The Concept of Risk When a bank issues a structured product to a client. 16. Due to the complexity of the financial world. the trader still has the risk associated with the volatility of the underlying. delta risk vega risk correlation risk second order risks The value of an option can vary over time because of several market parameters. Suppose that a bank sells an at-the-money call option on one underlying today to one of its clients. 60 . the most important risk to be hedged. and especially that of exotic products. the trader has still to verify the presence of second order risk like volga or vanna. The trader has always to assume an opposite position in the market (with respect to the issued products) in order to reflect the change in value of the derivative instruments. it is in fact selling a contract (under form of swap. In other words the trader has to be long (or be short) at any time an amount of the underlying asset so that if added to its delta position. This is achieved by buying (or selling) the right amount of shares (futures in case of indices) in order to have at all time (or as many time as possible) a flat delta position. This is often not related to the ability of the trader but rather to the nature of risk which has to be hedged away. The main components which have to be hedged away are the so-called first-order risk indicated above (delta. 2. This is not the case for cliquets and other unusual exotic payoffs. the market has not moved since the day we sold the option. without any doubt. 16. It is important to verify that the amount of shares traded per day corresponds to the delta of the product which has been sold since the trader.1 Delta Risk The delta represents for the trader. note or certificate) that ensures the holder receives a given percentage of the notional invested back. Liquidity is in this case a very important aspect which has to be analyzed when checking if a given underlying can be hedged or not. the hedges are far from being completely accurate.2 Vega risk Once the delta component is hedged away. 3. This option has a value X1 which can be estimated with the Black-Scholes equation as previously seen. depending on the performance of the underlying asset(s).

This is because of the attractiveness nature of low correlation. 61 . Consider. the investor is long a bond and a coupon X and is short a put down and in (with barrier B) on the worst performing stock. to buy volatility. but the notional invested is reduced by an amount corresponding to the highest drop among the stocks at maturity. usually represented by a big coupon or the capital protection. no influence when valuating an at-the-money vanilla call option. In case the condition is not verified. Consider now a barrier option. The Black-Scholes model would use the same volatility for the strike and for the barrier. The option is now worth X2 (where X2 is greater than X1 since a call is long vega). Skew effects have. This will. in fact. The model used in this case assumes a very important role. Due to the complexity of exotic products it is crucial to take into account all the effects that could affect their value. like a down-and-out put option with barrier at 60%. meaning that the payoff. in turn. There are products for which second order effects (second order derivatives with respect to a given market parameter) do not have to be taken into account. Consider a reverse convertible worst of where. the client still receives the coupon X. Due to the nature of the products sold over the past decade. banks are generally short on correlation. an at-the-money call option on a given underlying asset. the trader has. whereas the Local Volatility Model would consider two different volatilities because of presence of skew.4 Second order risks Modeling risk refers to the model used to evaluate the price of the derivative instrument. and therefore one or more stocks did trade below the barrier B. He receives therefore his notional back plus the coupon X if none of the underlying stocks ever traded below B. all the market parameters have not seen any change but the volatility of the underlying (on which the option is written). which has increased. In order to be hedged. leaving more to spend for the coupon X. depends on event that one (or more) of the N underlyings has touched a barrier or not. at maturity. for example. The lower the correlation the more attractive the final payoff will be for the investor. increase the probability of losing the capital protection at maturity. This option can be valued with the Black-Scholes model or with the more “sophisticated” Local Volatility Model and the price we would get would be exactly the same.Derivatives Suppose now that after the period t. By reducing the correlation we increase the probability of one of the shares touching the barrier B. therefore. This is especially the case for simple products like vanilla options or even simple exotic options. 16. 16. In order to have an attractive coupon it is in the investor’s interest to choose stocks with as low correlation as possible.3 Correlation risk Correlation risk is one of the most important and dangerous component to which banks are exposed. Suppose to have a generic products “worst of”.

it pays 0 otherwise. 62 . The option pays N if the underlying is above the strike K.1 Digital Call option. at time T2 > T1 (and closer to maturity).Derivatives 17 Discontinuities Discontinuities in the payoff are very common and they need to be analyzed in detail when pricing exotic derivatives.1 Digital call option A Digital Call option with strike K and paying an amount N at maturity T has the following Payoff: Payoff = N ⋅ I ( St > K ) Diagram 9 shows the payoff profile of a digital call option at maturity. 17. The black shape in diagram 10 represents the value of the digital call option at time T1 and its corresponding delta profile. As you can see. In the following section we describe the dynamic of a digital call option and the issues related to hedging. Payoff K St Diagram 18. the value of the option steepens around K and the delta tends to increase consequently.

By discontinuity we mean a point where the first derivative of the value of the option tends towards infinity. 63 . If we shift the strike K of the call to the left we notice that we decrease the value of the delta on the original strike. The other solution is the so-called barrier shift. We could therefore sell to the client a digital call option with strike K at a cost of a digital with strike K* (which is more valuable then a digital call with strike K) and hedge this option instead in order to avoid a delta tending to infinity. a) Shows the value of the digital option with the corresponding delta profile at time T1. we need to modify the payoff in order to take into account the effects of hedging a discontinuous payoff.2 Value and delta of a digital option as a function of strike K. in other words close to K and close to maturity the delta. We therefore observe a discontinuity in the payoff at maturity around K.2 Barrier shifts In order to keep the Δ finite. b) Shows the value of the digital option with the corresponding delta profile at time T2 > T1. ∂P ∂S 17. The most natural solution for a digital call option is to represent the payoff as a call spread. This is the case of digital options where for the limit of t -> Maturity the delta tends to assume infinite values.Derivatives Payoff t = T1 Δ t = T1 St K K St Payoff t = T2>T1 Δ t = T2>T1 St K K St Diagram 18. is given by: Δ= is a Dirac function.

3 Barrier shift and the effect on the delta of the option. In other words the CashFlowTrue will be paid at time if Ci is True otherwise CashFlowFalse will be paid.Derivatives Payoff K Payoff St St Δ K St Diagram 18. with interim payment cash flows at time ti with 0 < t1 < t2 < t3. 17.Ci is in this case a Boolean variable which can assume two value (True or False). T where the payment depends on the condition Ci . It is therefore necessary to give a formal definition of how a discontinuity can be estimated. . Let’s consider a product with maturity T. . Discontinuity (i ) = χ (i ) Ci =true + θ (i ) Ci =true − χ (i ) Ci = false − θ (i ) Ci = false Where: χ (i) C =true = is the intrinsic value of the product if the condition C i is true θ (i) C =true = is the time value of the product if the condition C i is true χ (i) C = false = is the intrinsic value of the product if the condition C i is false θ (i) C = false = is the time value of the product if the condition C i is false i i i i 64 . The formal definition of a discontinuity can be explained as follows.3 Evaluating the discontinuities Evaluating discontinuities in the payoff (or value of the product) could be misleading when dealing with exotic products..

Derivatives Example: 65 .

1 How to determine options prices There are various methods to estimate the value of derivative products. Schematically this can be seen like in diagram XX Dimensionality Monte Carlo Finite Difference Trees Closed formula Diagram 19.Derivatives 18 Pricing Techniques Once the model with which one will determine the value of the option has been chosen. For sufficiently simple products it is possible to determine closed formulas for option evaluation. They can be listed as follows: • • • Closed formula (analytical method) Finite difference and Trees (numerical methods) Monte Carlo Generically we could say that as the dimensionality of the problem increases (and therefore as its complexity increases) the use of a Monte Carlo approach becomes necessary. 18. This is not the case when dealing with exotic products. Usually it is the complexity of the derivative that determines whether an evaluation methodology is appropriate or not. In this case more sophisticated techniques have to be used as will be explained in the following sections. it is still necessary to select a pricing method.1 YYYYYYYYYYYYYYYYYYYYYYYY 66 .

and most natural. Closed formula definition: Under some condition a value V of an option with payoff f can be determined via a closed formula. Let’s consider the following equation: x 2 − 3x + 2 = 0 If we want to find the roots of this equation. The use of Finite difference or Trees becomes. an American call option where the holder has the right to early exercise the option. for example.3 Finite difference and Trees XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX 18. Let’s consider. Nevertheless it is very rare that the value of a derivative can be determinate by following this methodology. It is not possible to estimate an American call via a closed formula. T. r. V can therefore be written as: V = g(sigma. This is especially the case with more “exotic” structures where the complexity of the product requires a more powerful evaluation tool. We used an analytical approach to solve the equation.Derivatives 18. method to evaluate the solution of a mathematical problem. the interest rates. calculate the payoff of the option for all the 67 . therefore. d. maturity etc. A closed formula is a function f depending from some specific parameters of the underlying like the volatility. … ) The closed formula solution to the Black and Scholes differential equation has been determined by using an analytical approach. ( x − 1) ( x − 2) = 0 It is easy to see that the equation is equal to zero if and only if one of the two members is equal to zero this means: x −1 = 0 x−2=0 The solutions of the equation are therefore x = 1 and x = 2. the dividends.2 Closed formulas The analytical approach is the classical.4 The Monte Carlo method The Monte Carlo (MC) method allows us to analyze more complex problems (basket options. It enables us to find the exact solution to a well posed problem. The theory behind the MC approach is to use a random number generator to estimate the stochastic evolution of an asset. necessary 18. exotic payoffs etc). we can decompose the equation into the product of two members and subsequently evaluate the values for the variable x that satisfies the equation.

y ) i i . y 68 y i (x . Let’s discretize S’ in a finite number of smaller squares by dividing the x and the y axis in M intervals. calculate the average of the payoffs and discount it in order to obtain today’s value. When we determine the value V of an option with payoff f (and discounted payoff fd) with the MC approach we are effectively calculating the average of the function f on a set of randomly sampled points. We want to calculate the value of the surface of C via the MC methodology. Monte Carlo method definition: The Monte Carlo methodology (also called Monte Carlo Integration) is a stochastic technique for obtaining solutions of complex problems by means of random numbers. each one having a given probability of occurring. V= 1 M ∑ f d ( xi ) M i =1 18. Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY Considering the symmetry of the problem we can also analyze only one quarter of Figure XX.Derivatives stochastic paths. Figure XX shows the arc of circumference and the square S’ resulting from this operation.4.1 How does it work? Let’s consider a circle C circumscribed by a square S as illustrated in figure XX.

We also know that A= And that π l2 4 Q = l2 And therefore an estimate for the constant π is π ≈4 N M 69 . y j ) ⇒ (xi . y ) on S’ by means of a mapping function F: F : (x j . We can then denote the surface of the arc of circle with A and the surface of the square S’ with Q. the ratio of these two surfaces will be proportional to the ratio of random extracted points which fell inside and outside the area A: AreaArc A Po int sArc N = ≈ = AreaSquare Q TotalPo int s M For the limit of M going to infinity the ratios converge to each other and the expression above becomes an equality. We have seen that for a given set of M of sampling points A N ≈ Q M The ratio on the right hand side tends towards the left ratio for a sufficiently high population of sampling points.Derivatives Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY First we randomly extract M pairs of uncorrelated numbers and to associate them with the i i point (x . yi ) Let’s count the number of times N the point (xi. yi) falls inside the arc of circle. It is interesting to point out that the MC method applied to this simple geometric problem allows us to obtain an estimate of the constant π.

2 Estimating option prices with the MC method The procedure described in the previous section is very similar to that used to evaluate the price of an option. which is lognormally distributed. f3. we calculate the payoff f corresponding to each Si. we calculate the average of all the components of the vector fd. S3. f2. we calculate the discounted value of f. we evaluate the values assumed by S for all the different xi. …. fd. fd.3. we extract a vector U = [x1. …. xN] of N random numbers following a normal probability distribution function 2. obtaining a vector S = [S1. which corresponds to the value V of the option S S 100% f t Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY 70 . … .Derivatives 18. We want to calculate the value V of this option using the MC method. S2.4. …. x2. The procedure can be decomposed as follows: 1.N] 5. which will be as well a vector f = [f1. SN] 3. Let’s consider an exotic option with payoff at maturity described by the function f and having only one underlying S. x3.1. fd. called fd = [fd.2. fN] 4.

Derivatives 19 How to Avoid Errors 71 .

the value V of a vanilla option depends on several market variables: V (t ) = V ( S (t . μ ). 20.1 Overview It is a general mistake to define Hybrids as products where several market parameters have to be taken into account when estimating their fair value. the vanilla market values have to be matched) and where a correlation between different asset classes has to be taken into account.g. Payoff involving one asset class which is highly affected by stochastic behavior of other asset classes In both cases a specific model has to be used where each individual asset class is correctly priced (e. as we have seen in the initial chapters. 2. but not always. Payoff involving explicitly more asset classes 2. interest rates. for example the volatility and the forward. FX. like many other exotic options. T . foreign exchange.Derivatives 20 Hybrid Products The term Hybrid usually refers to structured products where the payoff is contingent to more than one asset class. treated by a specific team within the bank. Financial institutions are making big efforts to minimise these weaknesses by putting in places dedicated hybrid traders. such as equity. 72 . Equity. Hybrid products can usually categorized into two sub-categories: 1. are not “pure” hybrid products since all the non-equity variables can be hedged away in a static way. commodities. inflation etc. K . Choice of the underlyings (e. 3.) Construction of a single-asset model for each asset class involved Definition of a correlation factor between members of different asset classes Construction of a global multi-asset hybrid model Schematically this can be represented as in Diagram XXXX. 4. r ) Some of these are pure equity variables. Risk management tools are very sophisticated for single asset classes but are less flexible and manageable for multi asset classes. Interest Rates commodity etc. Vanilla options. σ . these kinds of products are often. This is obviously not the case since. Others are non-equity variables such as interest rates and foreign exchange (if quanto or compo). whereas equity variable have to be hedged in a dynamic way. The steps involved to build a proper hybrid multi-asset model can be listed as follows: 1.g. The reason behind this is that even if some of these underlyings follow the same stochastic process from a pricing point of view – which should in theory simplify the pricing – the risks involved from a trading point of view are quite different.

The correlation between IR and Equity affects Equity-Volatility surface convexity The convexity may. there are two major effects which have to be taken into account: 1. The actualization of each individual payment will be stochastic 2. This depends. of course.2 The impact of stochastic IR When we consider a model where Interest Rates have a stochastic behaviour. the volatility below the ATM level decreases 73 . or may not. The shape of the volatility surface is modified as follows: 1.1 YYYYYYYYYYYYYYYYYYYYYYYY 20. the volatility above the ATM level decreases 2. on the sensitivity of the product itself to the shape of the volatility surface.Derivatives Asset Class 1 (AC1) Asset Class 2 (AC2) Market Model (AC1) Market Model (AC2) Correlation AC1 – AC2 Hybrid Model Market Values Diagram 21. have a significant impact on the value of the option.

20% 0. for example. ATM Diagram 21.1% -0.1 YYYYYYYYYYYYYYYYYYYYYYYY 1 The sensitivity to the convexity is calculated by bumping the Hagan alpha parameter by 5% in relative value.30% Table 21. where the client gets at maturity the highest value of the index observed on a monthly basis. 74 .Derivatives The dotted line in diagram XXX shows how the surface is afffected.2 YYYYYYYYYYYYYYYYYYYYYYYY The reason for this is that the model calibrates to vanilla options. This product has the following sensitivities (values are taken as an example) Vega Skew Convexity 1 1. Let’s consider a 10Y lookback certificate. at each local point. the Black-Scholes volatility for vanilla options if we consider the stochastic behaviour of the rates but the local volatility will in general be different from a non-hybrid model. The Black-Scholes volatility (the volatility implied by the Black-Scholes model) can’t therefore to be deduced from the local volatility with the known formula Σ BS ( K ) = 1 σ (κ )dκ K −S ∫ S K There is an additional stochastic term coming from the Interest Rates which has to be taken into account. Basically the hybrid model is calibrated in order to match.

70% -0. The sensitivities are shown below: Vega Skew Convexity 0. If we increase the convexity the price of the certificate increases by 30 Bps. 75 . Let’s therefore consider a product which shows no sensitivity (or very small sensitivity) to convexity and skew but with a significant vega. we obtain the following results: Hybrid Model Equity Model 92.02% -0.4 YYYYYYYYYYYYYYYYYYYYYYYY The change in price here is very small because of the low sensitvity to the convexity.Derivatives As you can see the sensitivity to the convexity of the volatility surface is quite important. We’d expect. This is confirmed by the results shown in Table XXX Hybrid Model Equity Model 96.30% Table 21. we obtain a substantial difference in the price because of different local volatilities implied by the two models. therefore. It is therefore easy to see that the volatility surface is effectively deformed as described above.61% Table 21. that the hybrid model will show a cheaper price for a lookback certificate. This is the case of a barrier risk reversal 90 – 110 (the client is short a put strike 90% down and out at 70% and long a call strike 110% up and out at 130%). By pricing this option with the hybrid model and with a non-hybrid equity model.3 YYYYYYYYYYYYYYYYYYYYYYYY If we price this product with a hybrid model and with a non-hybrid equity model. the hybrid model reduces the convexity of the vol surface.004% Table 21.69% 92.2 YYYYYYYYYYYYYYYYYYYYYYYY One could suppose that the difference in the price arises from the high vega of the lookback (and therefore from a different deformation of the volatility surface like a parallel shift for example).80% 98. As we have seen.

a strip of CMS10Y digitals on the Eurostoxx50 (autocallable if above a barrier) 3.3 Specific case studies Covering all types of issues related to hybrid products would be beyond the scope of this book. We will consider the following combination of asset classes: 1.3 YYYYYYYYYYYYYYYYYYYYYYYY 76 .3. the client receives nothing otherwise.1.1 Equity – Interest Rates linked payoff In this section we’ll discuss hybrid products. Equity – Interest Rates linked payoff 2.3. Pure Equity (but with hybrid effects on Interest Rates) linked payoff 3.1 Strip of CMS10Y digitals on the Eurostoxx50 Let’s consider a 3 years product where the client receives. therefore. Usually the interest which is taken into account when dealing with Interest Rates is the CMS rate (Constant Maturity Swap rate). Diagramm XXX shows the CMS10Y linked coupon (red line) if the Eurostoxx50 peforms positively (yellow area) at the end of each year (dottet line). wheras the coupon would be zero if the Eurostoxx 50 performed negatively (grey area).Derivatives 20. where the payoff depends on the Equity and on the Interest Rates performance. Equity – Foreign Exchange linked payoff 20. “best of” between Eurostoxx50 and CMS10Y 20. Eurostox50 100% time Diagram 21. It corresponds to the rate associated to a swap where the maturity remains unchanged throughout the lifetime of the swap. each year. It is. a strip of CMS10Y digitals on the Eurostoxx50 2. the CMS10Y rate if the Eurostoxx50 performed positively (is above the strike) at the end of that year (since inception). The hybrid options we will analyze in this section are: 1. more suitable to proceed by analyzing some of the most common products and determine the effects of multi-asset pricing.

Ti −1 )(1 − P(Ti −1 . T1 )(1 − P (T1 .6 YYYYYYYYYYYYYYYYYYYYYYYY We have now to analyze what happens to the indicator function if Equity moves up. when we increase the correlation between Equity and Interest Rates 77 . T2 ))] + E [1 X 3 ⋅ P(T0 .3] The three terms in the expectation are going to determine if the presence of correlation between Interest Rates and Equity is going to increase the value of the option. T1 ))] + E [1 X 2 ⋅ P(T0 . In general. T3 ))] Where ⎧1 if S (i ) > S (0) 1 Xi = ⎨ ⎩ 0 otherwise And it is called the indicator function for Xi. The product of the discount factor and the individual floating amount increases if equity goes up. Let’s now analyze each individual expectation in the espression showing the floating payment. This is shown in table XXX 1 − P(Ti −1 . If the whole Interest Rates curve shifts by X% (without considering convexity effects involved) we can assume that the discount factor decreases by an amount which is smaller than the amount by which the CMS rate increases. P (Ti − 2 . As we have seen previously. Ti ))] for i=[2. T2 )(1 − P(T2 . they are E [1 Xi ⋅ P(Ti − 2 . Ti )) ↑ if Equity ↑ Table 21. Ti ) ↑↑ P(Ti − 2 . Let’s assume that the correlation is positive (the same reasoning can be done of course if a negative correlation is taken into account).5 YYYYYYYYYYYYYYYYYYYYYYYY The amount of arrows indicates the intensity of the changes if Equity (and therefore Interest Rates) moves up. Ti −1 )(1 − P(Ti −1 .Derivatives The conditional floating payment can be expressed as E [1 X 1 ⋅ (1 − P(T0 . Ti −1 ) ↓ if Equity ↑ if Equity ↑ Table 21.

introducing a correlation between IR and Equity has a significant impact on the Equity-skew.Derivatives we are effectively reducing the equity-skew and therefore we are reducing the probability for the equity being above strike at any observation date. above a barrier B (above the spot price).4 YYYYYYYYYYYYYYYYYYYYYYYY 20. a negligeable effect on the final price.7 YYYYYYYYYYYYYYYYYYYYYYYY The overall sensitivity of the sum of the expectations is directly proportional to the correlation between the two asset classes. on any annual observation date. as shown in Diagram XXX. The sensitivity of the individual expectations is summirized in table XXX. nevetherless.3. As we have seen before if we increase the correlation we are effectively increasing the value of the Interest Rate linked coupon whereas the change of the indicator function had no significant impact on the price. Price ρ Diagram 21. In this example the floating coupon is still subject to the same changes if the correlation increases. if Equity perofrms particularly well and trades. E [o] ↑ if Equity ↑ Table 21. It has. of the whole floating amount. this time.1. Any autocallable product has a given sensitivity to Equity-skew. As we said before. The product can be also called.2 Strip of CMS10Y digitals on the Eurostoxx50 (autocallable) Let’s consider the same product as in the previous section. then the price decreases). therefore. whereas the effect on the indicator function is not negligeable anymore. This effects tends to reduce the value of the expections and. 78 . If the autocallable barrier is above the spot level then the product has a negative sensitvity (if we increase the Equity-skew.

Derivatives 79 .

1 Accessing the data in the trading databases Market data is sourced from the trading databases such as Murex. Diva/Avid. but this is not a guarantee that it is completely upto-date.Derivatives 21 DIVA DIVA is a library of C++ implemented code developed by Commerzbank Corporates & Markets in order to price complex exotic products. The principle is similar to the C++ object-oriented language (for more information please refer to Annex 1). Xenomorph and the MDR. Diva Excel = av__( ) = feMarket__( ) = X__( ) Database AVID Murex Xenomorph MDR Diagram 22. The data can be accessed by functions which start with the following syntax: 1. The data is used for live pricing. = X__( ) for Xenomorph.1 YYYYYYYYYYYYYYYYYYYYYYYYY 21. 2. = feMarket__( ) for Murex 3. For example. which uses Excel as a graphical interface (for more information please refer to Annex 1) 21.2 DIVA Objects There are additional Financial Engineering functions which enable us to create specific objects containing market data and store them in the computer memory. = av__( ) for AVID. Diagram 1 shows how DIVA is linked to the trading database systems and the functions that are used to access the data. if we want to create an object containing the volatility of a given underlying. we will proceed in the following way: 80 .

Combining these three objects together we can evaluate the price of the product. The implementation specifies the numerical method that should be used to evauate the price of the derivative (MonteCarlo. repeat this process for all the data in the Market (IR.). dividends.2 YYYYYYYYYYYYYYYYYYYYYYYYY 21. Value. Date) 2. for example fixing dates and cashflows. you need three elements: a model. FiniteDifference and Trees). The product. The main steps to calculate the price for an option are: 1. Stocks rates volatilities dividends … Database Diagram 22.3 Pricing complex exotic products To price a product in Diva. associated to each Underlying (Indices or Socks) are created in the computer memory as a MarketDataCollection. vols. stochastic volatility. The model contains all the market data information on the underlyings. the model and the implementation are built in DIVA and stored in computer memory as an object. a Product object with the function =feCreateSplifeProduct( ) 81 . take its value from a database (here Murex) = feMarketVol(Index. Strike. MarketDataCollection Indices. The product contains details of the payoff.Derivatives 1. Date) 3. create 3 different objects: a. create an object containing the previous value = feCreateEquityBlackVolatilityMatrixMarket(Index. local volatility etc. and also information on how prices evolve with time (for example. a product and an implementation. …) 4. create an object combining all the data called a MarketDataCollection = feCreateMarketDataCollection( ) Diagram 2 shows how market data are withdrawn form the databases and how different Objects.

Model. payoff. There are two components to Easy Diva – the Model Builder spreadsheet. The inputs for the Model Builder spreadsheet are the Indices and/or 82 .…) b. maturity. 1. a Model object with the function =feCreateEquityModel( ) using the object MarketDataCollection as an input for the parameters of the underlyings c.b.c and 2. 1.3 YYYYYYYYYYYYYYYYYYYYYYYYY 21. MonteCarloImplementation) Diagram 3 is a graphical representation of the steps 1. and the product template spreadsheets.a.Derivatives which uses the SPLiFE language to describe the product in details (currency. an Implementation object with the function =feCreateImplementation( ) which gives the valuation method 2. Implementation) Diagram 22.4 Introduction to EasyDIVA EasyDIVA is a VBA based pricing tool which uses DIVA libraries functions to create models and implementation obects. use these objects as parameters to get the price with the function = feValueProduct(Product. Model. underlying. Product = feCreateSplifeProduct( ) Model = feCreateEquityModel( ) MarketDataCollection Implementation = feCreateImplementation( ) Price = feValueProduct(Product.

the type and name of the Model. Diagram 4 is a schematic representation of EasyDIVA’s structure (for more information please refer to annex B). After the model has been build the user needs to create a SPLiFE product in a separate spreadsheet and use the = priceproduct( ) function to evaluate the price. MonteCarloImplementation ) Diagram 22.Derivatives Stocks tickers. Product = feCreateSplifeProduct( ) Index/Stock tickers EasyDivaModelBuilder Model = feCreateEquityModel( ) MarketDataCollection MonteCarloImplementation = feCreateImplementationMonteCarlo( ) Price = priceproduct(Product. Model.4 YYYYYYYYYYYYYYYYYYYYYYYYY 83 . “No”.

the client gets 14% of the notional invested plus and the product redeems at 100%. If the product is never called the investor is exposed to the equity downside contingent to the past equity performance.a. but it is no more risky than a direct investment in the underlying. otherwise the client is long the underlying at maturity (let’s suppose 76% of initial spot as example). meaning that the investor gets the notional invested back regardless from any previous performance. If the Eurostoxx50 is above issue level (above 100%) then the client gets 7% of the notional invested and the prducts redeems at 100%. At the end of the third year If the Eurostoxx50 is below issue level (below 100%). he would get 121EUR at the end of the third year if the condition is satisfied. This means that if the client invested 100EUR. The downside has even a protection at maturity up to the trigger 84 . this structure has some downside risk with potential loss of a part of the investment. This means that if the client invested 100EUR. This means that if the client invested 100EUR. the product continues and we observe the level of the underlying at the end of the third year. If it is above issue level (above 100%). If it is above issue level (above 100%). the product continues and we observe the level of the underlying at the end of the second year. Strike level: 100% (of initial spot) At the end of the first year We observe the underlying on a yearly basis. at maturity. the product redeems at 100%. If. If the condition is satisfied the product redeems at 100%. he would get 107EUR at the end of the first year and the contract between the seller and the buyer is now closed. the client gets 21% of the notional invested plus and the product redeems at 100%. Advantages and disadvantages Thus. the product is not called and the a barrier has never been touched the client gets his notional back. 76EUR otherwise.Derivatives 22 Annexe A (Autocallable Products) 22. At the end of the second year If the Eurostoxx50 is below issue level (below 100%). he would get 114EUR at the end of the second year and the contract between the seller and the buyer is now closed. 100EUR if the conditin is not satisfied and the barrier never touched. In case the Eurostoxx50 is below the strike level (below 100%) but the barrier (65% of initial spot) has never been touched. otherwise the client is long the underlying (meaning that he’s short a put Down and In on the underlying) Example of Payoff Maturity: 3 years Currency: EUR Underlying: Eurostoxx50 (BBG Code: SX5E Index) Observation dates: yearly Barrier: 65% (of initial spot) Annualized amount: 7% p.1 Product Description The autocallable product is a structure which pays the investor a fixed annualized amount if the underlying reaches a given strike level at discrete observation dates.

or the underlying could increase highly. the notional + the autocall bonus). and the client receives an high bonus coupon. the product is autocalled and the client will receive €108 which is the notional + the autocall Bonus. the bonus earned is fixed at the agreement of the deal.4 YYYYYYYYYYYYYYYYYYYYYYYYY Second example: at the end of the first year. Diagram 22. So. the underlying stock closed equal to €110. and then the return may be less important than a direct investment (which is more risky). Payoff Examples For all the examples.e. the product is autocalled. the underlying stock closed equal to €105 (so to 105% of the initial strike). if this structure is autocalled. we see here that the return of this product is higher than a direct investment in the underlying. Diagram 22.Derivatives Besides. Then. and the client will receive €108 (i. we take the following structures: Maturity: 3 Years Initial Stock Price: €100 Strike Price: At the Money Autocall Bonus: 8% after the first year 16% after the second year 24% after the third year Barrier at maturity: 60% of the Strike First example: at the end of the first year. This time.4 YYYYYYYYYYYYYYYYYYYYYYYYY 85 . so the return could be either more important than a direct investment in the underlying. So. the return is less than for a direct investment in the underlying.

the client is no more protected. nor in the second year. so he will receive 1 share with a €55 notional. • • • Closing date at maturity: €105 => Client receives €124 (notional + call bonus at maturity) Closing date at maturity: €80 => Client is protected at maturity and he will receive €100 which is his initial investment Closing date at maturity: €55 => The barrier has been passed at maturity. and that his investment is not more risky than a direct investment in the underlying. The product is not autocalled the first year.4 YYYYYYYYYYYYYYYYYYYYYYYYY Fourth example: the product is called neither in the first year. the underlying stock closed equal to €95. The payoff of this derivative will now depend on the closing price at maturity. Then.Derivatives Third example: at the end of the first year.4 YYYYYYYYYYYYYYYYYYYYYYYYY We can see in those examples that the client is protected on the downside. Different cases may happen: • • • Closing price at the end of the 2nd year: €120 => Client receives €116 Closing price at the end of the 2nd year: €105 => Client receives €116 Closing price at the end of the 2nd year: €95 => Product is not called after the 2nd year Diagram 22. 86 . the deal continues until the next observation at the end of the second year. Diagram 22.

the clients receives shares. Otherwise. the client receives his 100% investment back. the underlying stock has never quoted below 60% of the strike. 87 . but the 100% redemption at maturity if the stock closes below 100% could also be conditioned by an american barrier: If at maturity. so without early redemption.Derivatives We must point out here that we have consider for our example an european barrier.

On the downside. So it will pay 108 after this first observation and then the deal is over whereas. 108% 100% 100% Diagram 22. To do this. we get the following graph. at each yearly observation there is a discontinuity that we have to estimate in order to properly shift the autocall triggers and barrier. the product is not called and we have to wait the second observation. If we only consider the payoff we expect to receive the day after the first observation. the initial investment is protected as long as a barrier is not reached.4 YYYYYYYYYYYYYYYYYYYYYYYYY On the right side. This derivative is autocallable early.2 Product Analysis Marketing points A salesperson can underline the following points to sell this product: On the upside. 88 . Discontinuities In this product. on the left side. If the product ends before the final maturity. sometimes with a return greater than in a direct investment.Derivatives 22. we can to use the formula: Discontinuity (i ) = χ (i ) Ci =true + θ (i ) Ci =true − χ (i ) Ci = false − θ (i ) Ci = false Where: χ (i) C =true = is the intrinsic value of the product if the condition C i is true θ (i ) C =true = is the time value of the product if the condition C i is true i i χ (i ) C = false = is the intrinsic value of the product if the condition C i is false θ (i ) C = false = is the time value of the product if the condition C i is false i i On the first year. the condition Ci is whether the closing price of the underlying is below (false) or above (true) the strike price. the product is in the money. the autocall gives a high bonus coupon. the client received back their notional early.

and will be ascending like the ascending coupon. In our example. the intrinsic value is the value of receiving the protection (€100) within two years. and the following graph represents the discontinuity each year: 124% 116% 108% 100% 100% Diagram 22. etc.4 YYYYYYYYYYYYYYYYYYYYYYYYY So. the shift in the 100% trigger will change every year. or being in the money at maturity. the trigger should be shifted towards the right in order to make the product more expensive. In that case. Discontinuity at maturity 89 . this effectively results in an ATM digital. Usually we consider that this value is have a total worth equal to close to 100%. 16% the second year and 24% the third year) As a general rule we need to shift the barrier according to the rule: 1% shift per 1 million discontinuity in terms of product notional. The same reasoning can be applied when the closing price is below the 60% protection. χ (i) + θ (i ) This calculation can be computed every year.Derivatives So. and the discontinuity will increase with the ascending coupon (discontinuity = 8% the first year. this value increases and it can happen that it is more convenient to not be autocalled the first years in order to receive the final high coupon at maturity. if the closing level of the underlying is below 100%. the product on the left side possesses both intrinsic and time value. However. Thus. if the closing price is above 60. on the right side. each year. This case means that the lefthand value is worth more than the righthand value due to the high coupon we could receive at maturity. the condition Ci is true. the intrinsic value is 108 and the time value is 0 because the deal will be over after this payment. we Ci = false Ci = false . with another intrinsic and temporal value. the value on the left side is not always 100% and depends on the ascending coupon. (so the condition Ci is false). So. being autocalled after the second year. On the other hand.g. whereas the time value takes into account the probabilities of all possible outcomes of the product life – e. If this coupon is quite high. because the probability to receive at least this value whenever the product terminates is quite high.

Long correlation: The lower the correlation. The following graph presents this discontinuity: 100% 60% 60% Diagram 22. Sensitivities: Let’s try to understand the sensitivities on the most common autocall we have to price: an autocall on the worst performer of a basket with an American barrier at maturity for the 100% redemption. so the lower the price. whereas this discontinuity is smaller if the observation is continuous.Derivatives Besides the European discontinuity at 100%.4 YYYYYYYYYYYYYYYYYYYYYYYYY If the observation at maturity is European. like in our example with the 60% trigger. so the lower the price. we are also short a put down and in at maturity.4 YYYYYYYYYYYYYYYYYYYYYYYYY 90 . Short skew: To understand that. This product is usually: Short Vega: the higher the volatilities. But a put D&I with a continuous (American) barrier is more frequent. This put could be valued according to European observation at maturity. the higher the chance to touch the barrier. and to make the put kick in. then the discontinuity at the 60% european barrier is worth 40%. let’s consider the following graph which is the payoff at maturity: 124% 100% 60% 60% Diagram 22. the higher the probability for one underlying to touch the down barrier.

the lower the volatility at a strike above 100%. the first sensitivity dominates. the higher the skew. Usually. However on the other hand. with the basic structure. which increases the price. the volatility at a stike below 100% is higher.Derivatives If the skew is higher. 91 . so the higher is the chance to be autocalled and to receive the payoff 100% + coupon. and the price decreases when the skew increases. so the probability to touch the barrier is higher and the price decreases.

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