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Lecture 14: Derivatives Theory (Part 1)

CHAPTER 6
Derivatives Theory (Part
1)
Todays Agenda
Introduction to financial
derivatives
3 Approaches to pricing
options
Delta Hedging Approach
Risk Neutral Valuation Approach
Replicating Portfolio Approach
Lecture 14: Derivatives Theory (Part 1)
2
Derivatives
Derivatives derive value from other
(underlying) securities.
Options are choices.
A call (put) option conveys the right (not
obligation) to purchase (sell) a security at a
given price within a given period of time.
Futures and forwards are devices for
trading an asset in the future.
Futures are exchange-traded forward
contracts.
Swaps typically involve exchanges
between counterparties of payment
streams over time.
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Lecture 14: Derivatives Theory (Part 1)
Options and Risk Management
Derivatives such as options,
futures, and forwards are widely
used for the purpose of managing
financial risks.
Limited liability creates option-like
payoffs for corporate owners and
creditors, and this has important
implications for corporate risk
management generally.
Lecture 14: Derivatives Theory (Part 1)
4
Approaches to Pricing Options
Next, we introduce the delta hedging,
risk neutral valuation, and replicating
portfolio approaches to pricing options.
Some Notation
T = Expiration date;
X = Exercise price;
S
T
= Price of the underlying asset at
expiration;
C
T
= Price of a call option at expiration;
and
P
T
= Price of a put option at expiration.
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Lecture 14: Derivatives Theory (Part 1)
Call (put) option definition and
payoff: A call (put) option conveys
the right to buy (sell) the
underlying asset at a
predetermined price and future
date, without any obligation.
Call Payoff: C
T
= Max[S
T
X, 0]
Put Payoff: P
T
= Max[X S
T
, 0]
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Lecture 14: Derivatives Theory (Part 1)
Approaches to Pricing Options
Binomial Model: One Timestep
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Lecture 14: Derivatives Theory (Part 1)
Example:
u =1.05
d =0.95
p =0.60
Current asset price S is 100
i.e., there is a 60% chance that in
one month, the stock price will be
$105 and a 40% chance it will be
$95.
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Lecture 14: Derivatives Theory (Part 1)
Delta Hedging Approach (Calls)
Suppose we hold a call option on this
asset with an exercise price of 100
that will expire in 1 month (ot = 1
month).
Holding just the stock or the option is
risky:
Holding just the stock: If the stock rises
we have $105, a profit of $5. If it falls we
have $95, a loss of $5.
Holding just the option: If the stock rises
we get a payoff of $5. If it falls, the option
expires out of the money.
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Lecture 14: Derivatives Theory (Part 1)
Delta Hedging Approach (Calls)
Delta Hedging Approach (Calls)
Lets sell short a quantity of the
underlying asset so that now we have
a portfolio consisting of a long call
option position and short stock
position.
If the asset rises to 105 we have a
portfolio worth
Max(105 100, 0) 105 = 5
105.
If the asset falls we have
Max(95 100, 0) 95 = 95.
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Lecture 14: Derivatives Theory (Part 1)
Suppose we choose such that
5 105 = 95, i.e., = .
Then the payoff on our portfolio one
month from now is $47.50,
irrespective of whether the stock
goes up or down!
Note that since our portfolio has a
riskless payoff, then it must earn the
riskless rate of return over the next
month.
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Lecture 14: Derivatives Theory (Part 1)
Delta Hedging Approach (Calls)
If C is the option value today then
our portfolios value is currently C
100.
The present value of the payoff on
this portfolio is e
-rt
($47.50).
Suppose r = 5%; then
C 100 = e
-rt
($47.50)
C = 50 e
-(.05)(1/12)
($47.50)
C = 50 47.30 = $2.70.
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Lecture 14: Derivatives Theory (Part 1)
Delta Hedging Approach (Calls)
Delta Hedging Approach (Puts)
Lets purchase a quantity of the
underlying asset so that now we have
a portfolio consisting of a long put
option position and long stock
position.
If the asset rises to 105 we have a
portfolio worth
Max(100 105, 0) + 105 = 105.
If the asset falls we have
Max(100 95, 0) + 95 = 5 + 95.
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Lecture 14: Derivatives Theory (Part 1)
Suppose we choose such that
105 = 5 + 95, i.e., = .
Then the payoff on our portfolio one
month from now is $52.50,
irrespective of whether the stock
goes up or down!
Note that since our portfolio has a
riskless payoff, then it must earn the
riskless rate of return over the next
month.
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Lecture 14: Derivatives Theory (Part 1)
Delta Hedging Approach (Puts)
Lecture 14: Derivatives Theory (Part 1)
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If P is the option value today then
our portfolios value is currently P +
100.
The present value of the payoff on
this portfolio is e
-rt
($52.50).
Suppose r = 5%; then
P + 100 = e
-rt
($52.50)
P = e
-rt
($52.50) 100
P = 52.28 50 = $2.28.
Delta Hedging Approach (Puts)
- Define as the annualized expected rate
of return on the stock. Note that:
o E(S
t
) = puS + (1-p)dS = e
t
S;
pu + (1-p)d = e
t
, and p = (e
t
d)/(ud).
- Since p = .60,
( )

o
+
=
ln (1 ) pu p d
t
=
( )
+ ln .6(1.05) (.4).95
.0833
= 11.94%
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Lecture 14: Derivatives Theory (Part 1)
Risk Neutral Valuation Approach
- Suppose r = 5%. Then the risk neutral
probability (q) is q = (e
rt
d)/(u-d) = .5417.
- The value of the call option is:
0
( , 0)
(1 ) ( , 0)
.9958(.5417(5)) $2.70.
r t
qMax uS X
C e
q Max dS X
o

| |
=
|
+
\ .
= =

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Lecture 14: Derivatives Theory (Part 1)
Risk Neutral Valuation Approach
- Using risk neutral valuation, the value
of an otherwise identical put option is:
0
( , 0)
(1 ) ( , 0)
.9958(.4583(5)) $2.28.
r t
qMax X uS
P e
q Max X dS
o

| |
=
|
+
\ .
= =

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Lecture 14: Derivatives Theory (Part 1)
Risk Neutral Valuation Approach
Replicating Portfolio Approach (Calls)
- Suppose we form a portfolio consisting of A shares of
(non-dividend paying) stock and $B in riskless bonds.
o The initial cost of forming such a portfolio is
$( ). S B A +
- After one period, the value of a call option replicating
portfolio in the up state is $( )
u
uS iB c A + = and in the
down state it is worth $( ) .
d
dS iB c A + =
- By setting
u d
c c
uS dS

A =

and
( )
d u
uc dc
B
i u d

, the payoffs on
this portfolio at nodes u and d replicate the call payoffs.

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Lecture 14: Derivatives Theory (Part 1)
Recall our previous numerical example. If u =1.05 and d
=0.95, then the date ot values for S
u
, S
d
, c
u
, and c
d
are $105,
$95, $5, and $0 respectively:

S
u
= $105
c
u
= $5
S

= $100
S
d
= $95
c
d
= $0

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Lecture 14: Derivatives Theory (Part 1)
Replicating Portfolio Approach (Calls)
Replicating Portfolio Approach (Calls)
Lets input the values from our previous numerical
example:

A = = =

= = =

= A + = =
5
0.5, and
10
1.05(0) .95(5)
47.30;
( ) 1.0042(0.10)
0.50(100) 47.30 $2.70.
u d
d u
c c
uS dS
uc dc
B
i u d
c S B

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Lecture 14: Derivatives Theory (Part 1)
Replicating Portfolio Approach (Puts)
- Suppose we form a portfolio consisting of A shares of
(non-dividend paying) stock and $B in riskless bonds.
o The initial cost of forming such a portfolio is
$( ). S B A +
- After one period, the value of a put option replicating
portfolio in the up state is $( )
u
uS iB p A + = and in the
down state it is worth $( ) .
d
dS iB p A + =
- By setting
u d
p p
uS dS

A =

and
( )
d u
up dp
B
i u d

, the payoffs on
this portfolio at nodes u and d replicate the call payoffs.

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Lecture 14: Derivatives Theory (Part 1)
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Lecture 14: Derivatives Theory (Part 1)
Recall our previous numerical example. If u =1.05 and d
=0.95, then the date ot values for S
u
, S
d
, p
u
, and p
d
are $105,
$95, $0, and $5 respectively:

S
u
= $105
p
u
= $0
S

= $100
S
d
= $95
p
d
= $5

Replicating Portfolio Approach (Puts)
Lets input the values from our previous numerical
example:

A = = =

= = =

= A + = + =
5
0.5, and
10
1.05(5) .95(0)
52.28;
( ) 1.0042(0.10)
0.50(100) 52.28 $2.28.
u d
d u
p p
uS dS
up dp
B
i u d
p S B

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Lecture 14: Derivatives Theory (Part 1)
Replicating Portfolio Approach (Puts)
Binomial Tree for a One-Step Call Option
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Lecture 14: Derivatives Theory (Part 1)
Binomial Tree for a One-Step Put Option
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Lecture 14: Derivatives Theory (Part 1)
We now derive an important relationship between the
price of a European put option P
0
and the price of an
otherwise identical European call C
0
. Consider the
following two portfolios:
Portfolio A: one European call option plus cash of $Xe
-
rT
.
Portfolio B: one European put option plus one share.
Both portfolios are worth Max(S
T
, X) at expiration of
the options. This is easily seen from the following
table:


S
T
X S
T
>X
Portfolio A Max(S
T
- X, 0) + X = X Max(S
T
- X, 0) + X = S
T

Portfolio B Max(X - S
T
, 0) + S
T
= X Max(X - S
T
, 0) + S
T
= S
T

Put-Call Parity
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Lecture 14: Derivatives Theory (Part 1)
Put-Call Parity
European options cannot be exercised
prior to the expiration date; therefore, the
portfolios must have identical values today;
i.e.,
C
0
+ Xe
-rT
= P
0
+ S
0
.
This equation represents the put-call parity
relationship, aka the "Fundamental
Theorem of Financial Engineering".
The payoff on any derivative or primary
security can synthetically created by forming a
portfolio of other derivatives and/or primary
securities.
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Lecture 14: Derivatives Theory (Part 1)
Put-Call Parity
If put-call parity doesnt hold, there are
arbitrage opportunities.
Suppose S
0
= $31, X=$30, r = 10%, T
= 3 months, C
0
= $3, and P
0
= $2.25.
Portfolio A Value: C
0
+ Xe
-rT
= 3+30e
-.1(.25)

= 32.26.
Portfolio B Value: P
0
+ S
0

= 2.25 + 31 =
33.25.
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Lecture 14: Derivatives Theory (Part 1)
Implications of adding a Time
Step
- Now suppose that we add another time-step; i.e., time
to expiration is now 2 years rather than 1 year. This
results in the following binomial tree:

$100
$95
$105
$110.25
$99.75
$90.25
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Lecture 14: Derivatives Theory (Part 1)
Since uuS

= $110.25, udS

= $99.75, and ddS

= $90.25,
this implies that
c
uu
= Max[110.25-100,0] =$10.25 and p
uu
=Max[100-
110.25,0]

= $0,
c
ud
= Max[99.75-100,0] = $0 and p
ud
=Max[100-99.75,0] =
$0.25, and
c
dd
= Max[90.25-100,0] =$0 and p
dd
= Max[100-90.25,0] =
$9.75.
Since the risk neutral probability of an up move is
.5418 and the interest rate is 5%, this implies the
following prices for c
u
, p
u
, c
d
, p
d
, c, and p:
c
u
= e
-.05
[(.5418)10.25 + (.4582)0] = $5.53 and p
u
= e
-
.05
[(.5418)0+ (.4582)0.25] = $0.11,
c
d
= 0 and p
d
= e
-.05
[(.5418).11+ (.4582)9.75] = $4.58,
c = e
-.05
[(.5418)5.53] = $2.98 and p = e
-.05
[(.5418).11+
(.4582)4.58] = $2.15.


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Lecture 14: Derivatives Theory (Part 1)
Implications of adding a Time
Step
Binomial Tree for a Two-Step Call Option
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Lecture 14: Derivatives Theory (Part 1)
Binomial Tree for a Two-Step Put Option
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Lecture 14: Derivatives Theory (Part 1)