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IS-1 Financial Primer

Stochastic Modeling
Symposium
By
Thomas S.Y. Ho PhD
Thomas Ho Company, Ltd
Tom.ho@thomasho.com
April 3, 2006

Purpose
Overview of the basic principles in the
relative valuation models
Overview of the basic terminologies

Equity derivatives
Fixed income securities

Practical implementation of the models


Examples of applications

Traditional Valuation
Net present value
Expected cashflows
Cost of capital as opposed to cost of
funding
Capital asset pricing model
Cost of capital of a firm as opposed to cost
of capital of a project (or security)

Relative Valuation
Law of one price: extending to nontradable financial instruments
Applicability to insurance products and
annuities (loans and GICs)
Arbitrage process and relative pricing

Stock Option Model


Modeling approach: specifying the
assumptions, types of assumptions
Description of an option
Economic assumptions:

Constant risk free rate


Constant volatility
Stock return distribution
Efficient capital markets

Binomial Lattice Model


Generality of the model in describing the
equity return distribution
Market lattice and risk neutral lattice
Dynamic hedging and valuation
Intuitive explanation of the model results
Comparing the relative valuation approach
and the traditional approach the case of
a long dated equity put option

One-Period Binomial Model

Su/S > exp(rT)> Sd/S

In the absence of arbitrage opportunities, there


exist positive state prices such that the price of
any security is the sum across the states of the
world of its payoff multiplied by the state price.
=(Cu Cd)/(Su -Sd )

u =(S- exp(-rT) Sd )/(Su - Sd )

C = uCu + dCd

S=

1 = uexp(rT)+ dexp(rT)

uSu + dSd

Numerical Example: Call


Option Pricing
Stock Price($)

100

Strike Price ($)

100

Stock Volatility

0.2

Time to expiration (year)

Risk-free rate

0.05

dividend yields

N/A

the number of periods

dt = T/n

upward movement

1.0851

= exp(dt)

downward movement

0.9216

= 1/u

risk-neutral probability of u

0.5308

= (exp(rdt)-d)/(u-d)

Stock lattice
163.21
4965

stock lattice
time

150.41
8059

138.62
4497

138.62
4497

127.75
5612

117.738
905

127.75
5612

117.738
905

108.50
756

100

117.738
905

108.50
756

100

92.159
4775

84.933
693

108.50
756

100

92.159
4775

84.933
693

78.274
4477

72.137
3221

100

92.159
4775

84.933
693

78.274
4477

72.137
3221

66.481
3791

61.268
8917

Call Option Lattice


63.214965

10.125573

51.247930

38.624497

40.277352

28.585483

17.738905

30.224621

19.391759

9.337430

0.000000

21.723634

12.494533

4.915050

0.000000

0.000000

15.055460

7.780762

2.587191

0.000000

0.000000

0.000000

4.729344

1.361849

0.000000

0.000000

0.000000

0.000000

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Martingale Processes, p and q


measures

C/R = puCu/Ru + pdCd/Rd

S/R = puSu/Ru + pdSd/Rd

1 = pu + pd

C/S = quCu/Su + qdCd/Sd

R/S = quRu/Su + qdRd/Sd

1 = qu + qd

Probability measure: assigning prob


Denominator: numeraire
Martingale: expected value= current value

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Continuous Time Modeling

Ito process

dX(t) = (t)dt + (t)dB(t)


(dt)2 =0
(dt)(dB)=0
(dB)2 =dt

Z = g( t, X)

dZ = gt dt + gXdX + 1/2 gxx (dX)2

Geometric Brownian motion


dS/S =dt + dB(t)
S(t) = S(0)exp (t - 2t/2 + B(t))

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Numeraires and
Probabilities

dS/S = s dt + sdBs(t) dividend paying


dV/V = qdt + dS/S dividend re-invested
dY/Y = * dt + *dB*(t) any asset
R(t) = integral of r(s) stochastic rates
Risk neutral measure

Z(t) = V(t)/R(t)
dS/S = (r- q) dt + sdB(t)

V as numeraire

Z(t) = R(t)/V(t)
dS/S = (r q + s2)dt + s dB
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Numeraire General Case

Y as numeraire

Z(t) = V(t)/Y(t)
dS/S = (r q + s y)dt + s dB

Volatility invariant

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Risk Neutral Measure


Martingale process
Examples of measures

p measure, forward measure, market measure

Generalization of the Black-Scholes Model


Applications in the capital markets
Applications to the insurance products

Life products
Fixed annuities
Variable annuities
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Sensitivity Measures

Delta , S
Gamma ,
Theta (time decay) t
Vega v measure
Rho , r
Relationships of the sensitivity measures
Intuitive explanation of the greeks

European, American, Bermudian, Asian put/call options

Comparing with the equilibrium models

Continual adjustment of the implied volatility


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Stock Price (S)

100

Strike Price (K)

100
?

Time to expiration (T)

Stock volitility ()

0.2

Risk-free rate (r)

0.04

Dividend yields ()

0
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Numerical Example of the


Greeks
Call

Put

Price

9.92505

6.00400

(Delta)

0.61791

-0.38209

(Gamma)

0.01907

0.01907

v (Vega)

38.13878

38.13878

(Theta)

-5.88852

-2.04536

(Rho)

51.86609

-44.21286

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Interest Rate Modeling


Lattice models
Yield curve estimation
Yield curve movements
Dynamic hedging of bonds
Term structure of volatilities
Sensitivity measures

Duration, key rate duration, convexity

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Interest Rate Model:


Setting Up
year

initial yield curve

initial discount function p(n)

one period forward curve

0.060

0.060

0.065

0.070

0.075

0.080

1.00000
0

0.94176
5

0.87809
5

0.81058
4

0.74081
8

0.67032
0

0.060

0.060

0.070

0.080

0.090

0.100

lognormal spot volatility (S)

0.0775

0.0775

0.0775

0.0775

0.0775

lognormal forward volatility (f)

0.0775

0.0775

0.0775

0.0775

0.0775

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Ho Lee (basic) Model


0.86124
1
P (n 1)
i
Pi (1) 2

n
P(n) (1 )
n

0.87964
7

0.87469
5

0.89695
1

0.89200
4

0.88835
8

0.91310
5

0.90814
3

0.90453
4

0.90223
5

0.92805
8

0.92306
6

0.91947
4

0.91724
1

0.91632
8

Discount function lattice

0.94176
5

0.93672
9

0.93313
6

0.93094
6

0.93012
6

0.93064
2

year

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Ho-Lee One Period Rates


0.14938
06
ln Pi n (T )
ri (T )
T
n

0.12823
51

0.13388
06

0.10875
38

0.11428
51

0.11838
06

0.09090
47

0.09635
38

0.10033
51

0.10288
06

0.07466
08

0.08005
47

0.08395
38

0.08638
51

0.08738
06

Interest rate lattice

0.06

0.06536
08

0.06920
47

0.07155
38

0.07243
51

0.07188
06

year

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P( n 1)

P ( n)

Pi n (1)

1 n1 n2 1 1 n1 2

1 n 1 1 n 2 1 n

ni

0.86673
1

0.926800

0.94176

0.88096
3

0.87807
2

0.89598
0

0.89266
8

0.88956
2

0.9
11
39
5

0.90779
5

0.90453
0

0.90120
1

0.9
23
04
4

0.91976
5

0.91654
9

0.91299
4

0.9
34

23
0.93189

0.92872

0.92494


P ( n 1)
1 n 1 n 2 L 1 L 1 n 1 2

P ( n)

1 n L 1 1 n L 2 L 1 n

ni

Pi n (1)

lognormal spot volatility (S)

0.1

0.095

0.09

0.085

0.08

lognormal forward volatility (f)

0.1

0.0907143

0.081875

0.0733333

0.065

Ho-Lee
model rates
with term
structure of
volatilities

0.1430264

0.1267402

0.1300264

0.1098368

0.1135402

0.1170264

0.0927784

0.0967368

0.1003402

0.1040264

0.076018

0.0800784

0.0836368

0.0871402

0.0910264

0.06

0.064018

0.0673784

0.0705368

0.0739402

0.0780264

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Alternative Arbitrage-free
Interest Rate Modeling

These are not economic models but


Techniques
techniques
Spot rate model
N-factor model
Lattice model
Continuous time model
Calibrations

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Alternative Valuation
Algorithms

Discounting along the spot curve


Backward substitution
Pathwise valuation

monte-carlo
Antithetic, control variate
Structured sampling

Finite difference methods

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Example of Interest Rate


Models

Ho-Lee, Black-Derman-Toy, Hull-White


Heath-Jarrow-Morton model
Brace-Gatarek-Musiela/Jamshidian model
(Market Model)
String model
Affine model

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Examples of Applications

Corporate bonds (liquidity and credit risks)

Option adjusted spreads

Mortgage-backed securities

Prepayment models
CMOs

Capital structure arbitrage valuation


Insurance products

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Conclusions
Comparing relative valuation and the NPV
model
Imagine the world without relative
valuation
Beyond the Primer:

Importance of financial engineering


Identifying the economics of the models

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References
Ho and Lee (2005) The Oxford Guide to
Financial Modeling Oxford University Press
Excel models (185 models)
www.thomasho.com
Email: tom.ho@thomasho.com

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