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IB2660 Lecture 17 v1.3
IB2660 Lecture 17 v1.3
Version 1.3
Term Schedule
Week Material
01: Oct 03 Lecture 01: Math Refresher (Optional Self-Study), Lecture 02: Investment Under Certainty, Lecture 03: Risk and Expected Return
Seminar: No Seminars, please read math refresher
Reading: Stitz and Zeager (2013, optional, Chapters 1.3–1.4, 6.1-6.2, and 9.1-9.2), Hillier et al. (2016, optional, Chapters 4.1–4.4 and 5.1–5.3), Hartman et al. (2018, optional, Chapters 1.1–1.3 and
2.1-2.6), Diez et al. (2015, optional, Chapters 2.4–2.6 and 7.1–7.2); Hillier et al. (2016, Appendix 4A); Hillier et al. (2016, Chapters 9.1–9.6), Bodie et al. (2014, Chapters 5.3–5.5 and 18.2)
02: Oct 10 Lecture 04: Risk Aversion and Expected Utility I, Lecture 05: Risk Aversion and Expected Utility II
Seminar: Problem Set 01 (Financial Arithmetic, Investment under Certainty)
Reading: Bodie et al. (2014, Chapter 6.1); Bodie et al. (2014, Chapter 6.1)
03: Oct 17 Lecture 06: Optimal Portfolio Selection I, Lecture 07: Optimal Portfolio Selection II
Seminar: Problem Set 02 (Uncertainty and Risk Aversion)
Reading: Hillier et al. (2016, Chapters 10.1–10.7), Bodie et al. (2014, Chapters 6.2–6.6, 7.1–7.4, and 8.1-8.2); Hillier et al. (2016, Chapters 10.1–10.7), Bodie et al. (2014, Chapters 6.2–6.6, 7.1–7.4, and
8.1-8.2), Solnik (1974, optional), Elton et al. (2011)
04: Oct 24 Lecture 08: Capital Asset Pricing Model I, Lecture 09: Capital Asset Pricing Model II
Seminar: Problem Set 03 (Optimal Portfolio Selection)
Reading: Hillier et al. (2016, Chapters 10.8–10.10, and 12.1–12.3), Bodie et al. (2014, Chapters 9.1–9.4), Fama and French (1992); Hillier et al. (2016, Chapters 10.8–10.10, and 12.1–12.3), Bodie et al.
(2014, Chapters 9.1–9.4)
06: Nov 07 Lecture 10: Market Efficiency I, Lecture 11: Market Efficiency II
Seminar: Review Problem Sets 01–04
Reading: Hillier et al. (2016, Chapters 13.1–13.3, and 13.5), Bodie et al. (2014, 11.1 and 11.2); Hillier et al. (2016, Chapters 13.4, and 13.6–13.8), Bodie et al. (2014, pp. 11.3–11.5), Basu (1977), Carhart
(1997), Fama, Fisher, et al. (1969), Jensen (1968), Rendleman et al. (1982), Jegadeesh and Titman (1993)
07: Nov 14 Lecture 12: Bond Pricing I, Lecture 13: Bond Pricing II
Seminar: Problem Set 05 (Market Efficiency)
Reading: Hillier et al. (2016, Chapters 5.1–5.3, and Appendix 5A), Bodie et al. (2014, 5.1, 15.1–15.5, and 16.1); Hillier et al. (2016, Chapters 5.1–5.3, and Appendix 5A), Bodie et al. (2014, 5.1, 15.1–15.5,
and 16.1)
08: Nov 21 Lecture 14: Forwards and Futures I, Lecture 15: Forwards and Futures II
Seminar: Problem Set 06 (Bond Pricing)
Reading: Hillier et al. (2016, Chapters 25.1–25.3), Bodie et al. (2014, Chapters 22.1,22.2, 22.4), Hull (2015, pp. 1.1–1.10, 2.1–2.7, 3.1–3.2, 5.1–5.8); Hillier et al. (2016, Chapters 25.1–25.3), Bodie et al.
(2014, Chapters 20.1, 20.2, 20.4), Hull (2015, 1.1–1.10, 2.1–2.7, 3.1–3.2, and 5.1–5.8)
Lecture 01: Math Refresher (Optional Self-Study) Lecture 10: Market Efficiency I
Lecture 02: Investment Under Certainty Lecture 11: Market Efficiency II
Lecture 03: Risk and Expected Return Lecture 12: Bond Pricing I
Lecture 04: Risk Aversion and Expected Utility I Lecture 13: Bond Pricing II
Lecture 05: Risk Aversion and Expected Utility II Lecture 14: Forwards and Futures I
Lecture 06: Optimal Portfolio Selection I Lecture 15: Forwards and Futures II
Lecture 07: Optimal Portfolio Selection II Lecture 16: Options I
Lecture 08: Capital Asset Pricing Model I Lecture 17: Options II
Lecture 09: Capital Asset Pricing Model II Lecture R2: Review of Part II
Lecture R1: Review of Part I
Lecture 17: Options II
Overview of Topics
Reading: Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and 21.1–21.3), Hull (2015, Chapters 10.1–10.5,
11.1–11.7, 13.1–13.6)
Note: Sections marked by * are covered in prerecorded videos or reserved for self-study. All material is examinable unless otherwise stated.
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u1 d0 50 %
50.0%
S0
50.0%
S0 u0 d1 50 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u2 d0 25 %
25.0%
50.0%
S0 S0 u1 d1 50 %
50.0%
25.0%
25.0%
S0 u0 d2 25 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u3 d0 12.5 %
12.5%
25.0%
S0 u2 d1 37.5 %
25.0%
50.0% 12.5%
S0
50.0% 12.5%
25.0%
S0 u1 d2 37.5 %
25.0%
12.5%
12.5%
S0 u0 d3 12.5 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u4 d0 6.3 %
6.3%
Length of Time Step: 1/4 Period
6.3%
12.5%
S0 u3 d1 25 %
12.5%
25.0% 6.3%
25.0% 6.3%
50.0% 12.5%
S0 S0 u2 d2 37.5 %
50.0% 12.5%
25.0% 6.3%
25.0% 6.3%
12.5%
S0 u1 d3 25 %
12.5%
6.3%
6.3%
S0 u0 d4 6.3 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u5 d0 3.1 %
3.1%
Length of Time Step: 1/5 Period
6.3% 3.1%
S0 u4 d1 15.6 %
12.5% 6.3% 3.1%
3.1%
S0 u0 d5 3.1 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u6 d0 1.6 %
1.6%
1.6%
S0 u0 d6 1.6 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
From binomial option pricing to Black Scholes
Value of Underlying
and Binomial Probability
S0 u7 d0 0.8 %
0.8%
0.8%
S0 u0 d7 0.8 %
Remarks:
I Initial underlying price S0 has equal up and down probabilities with ever-finer time steps
I As time steps per period increase, underlying price approaches the normal distribution
1/12
Black Scholes option pricing formulae for calls (Ct ) and puts (Pt )
ln P VS(X)
t
1 p
Ct = St N (d1 ) − P V (X)N (d2 ) d1 = p + σ (T − t)
σ (T − t) 2
p
Pt = P V (X)N (−d2 ) − St N (−d1 ) d2 = d1 − σ (T − t)
Notation:
St underlying spot price at time t
N (·) cumulative probability distribution function for a std normal random variable
P V (·) present value operator, discounting at risk-free rate
X exercise price for the option
T − t time to expiry for the option
σ standard deviation of annualized continuously compounded stock return
2/12
Black Scholes call price: similar to the binomial call price
Remarks:
I Note the similarity between replicating portfolios in these two pricing models
I Black Scholes replicating portfolio: long N (d1 ) stocks and short P V (X)N (d2 ) bonds
I Binomial replicating portfolio: long ∆ stocks and short B bonds
I N (d1 ) matches ∆ of the binomial option price, P V (X)N (d2 ) matches B
3/12
Finding the Black-Scholes call value
h h
Ct = Et e−R(T −t) max(0, ST − X)
Z ∞
−R(T −t)
=e (ST − X)p(ST )dST
ZX∞ Z ∞
−R(T −t)
=e ST p(ST )dST − P V (X) p(ST )dST
X X
= St N (d1 ) − P V (X)N (d2 )
Remarks:
I For a risk-neutral investor, the call value equals the expected present payoff value
I N (d2 ) represents the risk-neutral probability a call option will be exercised
I St N (d1 ) represents the present value of the expected stock price in a risk-neutral work
when prices less than X are counted as zero
4/12
Finding the Black-Scholes put value
Pt = Ct + P V (X) − St
Remarks:
I First equality uses the no-arbitrage condition of put-call parity: Ct + P V (X) = St + Pt
I Second equality substitutes the Black Scholes formula for the European Call
I Third equality uses N (−d1 ) = 1 − N (d1 ) and N (−d2 ) = 1 − N (d2 )
5/12
Interpretation of the Black Scholes formulae
I Black-Scholes formula implies that a long position in a European-style call option is
equivalent to a long position in a replicating portfolio that is simultaneously:
I long N (d1 ) shares of underlying asset S
I short N (d2 ) units of riskless bond P V (X) that pays X at expiry date
I Value of call option and value of replicating portfolio change by same amount in
response to small change in value S of underlying asset
I call option delta ∆ = N (d1 ) measures call’s sensitivity to small changes in S
I if S increases by +1, C increases by ∆ = N (d1 )
I The term N (d2 ) is a risk-neutral probability of exercising the European call at expiry
6/12
Lecture 17: Options II
Overview of Topics
Reading: Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and 21.1–21.3), Hull (2015, Chapters 10.1–10.5,
11.1–11.7, 13.1–13.6)
Note: Sections marked by * are covered in prerecorded videos or reserved for self-study. All material is examinable unless otherwise stated.
Black-Scholes model: a numerical example
Question 1 199-501-834
Remarks:
I Solve this problem in a few steps using the Black Scholes formulae given above
√
I First, compute P V (X), then σ T − t, then d1 and d2 , then look up N (d1 ) and N (d1 )
7/12
Black-Scholes model: a numerical example
Solution 1 199-501-834
7/12
Lecture 17: Options II
Overview of Topics
Reading: Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and 21.1–21.3), Hull (2015, Chapters 10.1–10.5,
11.1–11.7, 13.1–13.6)
Note: Sections marked by * are covered in prerecorded videos or reserved for self-study. All material is examinable unless otherwise stated.
The Greeks: partial derivatives of option prices with respect to:
S spot price
T time to expiry
σ volatility
R riskless rate
Remarks:
I Mathematically, the Greeks are partial derivatives, e.g. ∂C/∂S = ∆, i.e. “Delta”
I We study how each variable effects the option price, holding other variables constant
I The effects can differ depending on option type: American versus European options
I The effect of changes in exercise price X should be clear . . .
8/12
The Greeks: European Options
Remarks:
I The variable Π represents an option value, i.e. Π = C for calls, Π = P for puts
I Increase in underlying price S raises value of call, reduces value of put
p
I Time to expiry affects volatility σ (T − t) ↑ and present value P V (X) ↓
9/12
The Greeks: American Options
Remarks:
I Assuming a non-dividend yielding asset, American call options are equivalent to
European call options
I American puts have payoff max(0, X − St ) at expiry; more time to expiry increases
value unambiguously
10/12
Lecture 17: Options II
Overview of Topics
Reading: Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and 21.1–21.3), Hull (2015, Chapters 10.1–10.5,
11.1–11.7, 13.1–13.6)
Note: Sections marked by * are covered in prerecorded videos or reserved for self-study. All material is examinable unless otherwise stated.
Limitation 1: Constant volatility versus Implied volatility
11/12
Limitation 2: Normal distribution
0.6
0.5
0.4
Frequency
0.3
0.2
0.1
0.0
4 2 0 2 4
Daily Return
Remarks:
I Black Scholes formula assume stock returns follow a normal distribution
I In practice, the distribution of stock returns is fat tailed
I Investors will pay higher premia for call options insuring against large price drops
12/12
Cumulative Standard Normal Distribution Probability Tables
Reading: Hillier et al. (2016, Chapters 22.1–22.8), Bodie et al. (2014, Chapters 20.1, 20.2, 20.4, and 21.1–21.3),
Hull (2015, Chapters 10.1–10.5, 11.1–11.7, 13.1–13.6)
References I
I Basu, S. (1977). Investment performance of common stocks in relation to their price-earnings ratios: A test
of the efficient market hypothesis. Journal of Finance, 32(3), 663–682.
I Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th). McGraw Hill.
I Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57–82.
I Diez, D., Barr, C., & Çetinkaya-Rundel, M. (2015). Openintro statistics (3rd ed.).
I Elton, E. J., Gruber, M. J., Brown, S. J., & Goetzmann, W. N. (2011). Modern portfolio theory and
investment analysis (8th). John Wiley & Sons.
I Fama, E. F., Fisher, L., Jensen, M. C., & Roll, R. (1969). The adjustment of stock prices to new information.
International Economic Review, 10(1), 1–21.
I Fama, E. F. & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance,
47(2), 427–465.
I Hartman, G., Siemers, T., Heinold, B., & Chalishajar, D. (2018). Apex calculus (4.0). (J. Bower, Ed.).
I Hillier, D., Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate finance (3rd European
Edition). McGraw Hill.
I Hull, J. C. (2015). Options, futures, and other derivatives (9th). Pearson Education.
References II
I Jegadeesh, N. & Titman, S. (1993). Returns to buying winners and selling losers: Implications for stock
market efficiency. Journal of Finance.
I Jensen, M. C. (1968). The performance of mutual funds in the period 1945-1964. Journal of Finance,
23(2), 389–416.
I Rendleman, R. J., Jones, C. P., & Latane, H. A. (1982). Empirical anomalies based on unexpected
earnings and the importance of risk adjustments. Journal of Financial Economics, 10(3), 269–287.
I Solnik, B. H. (1974). Why not diversify internationally rather than domestically?. Financial Analysts
Journal, 30(4), 48–54.
I Stitz, C. & Zeager, J. (2013). Precalculus (3rd Corrected). Stitz Zeager Open Source Mathematics.