Option Pricing – BS Model

Assumptions:
 European option
 The price of the underlying follows a lognormal
distribution
 Risk free is constant and same for all maturities
 Markets are frictionless: Absence of transaction costs &
taxes
 Volatility of the underlying is known & constant
 The underlying asset has no cash flows
 Price formulae

 rcT
c  S0N(d1)  X e N(d2 )
rcT
pXe [1 - N(d2 )]  S0 [1  N(d1)]

 c  / 2)T
2
where d1  ln(S / X
0 ) (r
 T
d2  d1 T
Opening up the abbreviations
 c = Price of call option

 p = Price of put option

 S0 = Spot price

 X = Strike Price

 T = Time to Maturity (as % of 365 day year)

 rc = continuous compounded risk free rate

  = Implied Annualised Volatility

 N(w) = cumulative normal probability

 VALUE AT RISK (VAR)
For investors, risk is about the odds of losing money,
and VAR is based on that common-sense fact. By
assuming investors care about the odds of a really big
loss, VAR answers the question, "What is my worst-
case scenario?" or "How much could I lose in a really
bad month?"

A VAR statistic has three components:

a time period,
a confidence level
a loss amount (or loss percentage)
METHODS OF CALCULATING VAR

Historical Method

The Variance-Covariance Method

Monte Carlo Simulation

HISTORICAL METHOD
INTERPRETATION OF HISTORICAL METHOD

With 95% confidence, we expect that our worst daily

loss will not exceed 4%.

If we invest $100, we are 95% confident that our worst

daily loss will not exceed $4 ($100 x -4%).

With 99% confidence, we expect that the worst daily

loss will not exceed 7%.

Or, if we invest $100, we are 99% confident that our

worst daily loss will not exceed $7.
THE VARIANCE-COVARIANCE METHOD
MONTE CARLO SIMULATION
INTERPRETATION OF MONTE CARLO SIMULATION

we ran 100 hypothetical trials of monthly

returns for U/L.

Among them, two outcomes were between -

15% and -20%; and three were between -20%
and -25%.
That means the worst five outcomes (that is,
the worst 5%) were less than -15%.

therefore it leads to the following VAR-

type conclusion: with 95% confidence, we do
not expect to lose more than 15% during any
given month.