Pricing Model of Financial Engineering

Fang-Bo Yeh System Control Group Department of Mathematics Tunghai University
www.math.thu.tw/~fbyeh/

Glasgow
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Newcastle Groningen

IEEE M. Barry Carlton Award

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Contents
1. 2. 3. 4. Classic and Derivatives Market Derivatives Pricing Methods for Pricing Numerical Solution for Pricing Model

gold ) Fixed income ( T-bonds ) ‡ Contracts Forward & Swap : FRAs . Convertibles Bond Option. JPY ) . Floors. Interest Rate Swaps Stock Equities ( AOL stock ) Equity indexes ( S&P 500 ) Futures & Options : Options. Caps.Classic and Derivatives Market ‡ Underlying Assets Cash Commodities ( wheat. Swaptions Currency Currencies ( GBP.

Exotics«. ‡ Call Option : gives its owner the right but not the obligation to buy a specified asset on or before a specified date for a specified price. Asian.. Capped. 5 . American. European.Derivative Securities ‡ Forward Contract : is an agreement to buy or sell. Lookback.

8.000 ‡ otherwise.Call Option on AOL Stock on Sep.call option contract written on AOL contract size: 100 shares strike price: 80 maturity: December 26 option premium: 71/8 per share on Sep. 8.« ‡ if you exercise the option.« ‡ you pay the premium of $712. nothing happens 6 . you take delivery of 100 shares of AOL stock and pay the strike price of $8. you buy one Nov.50 at maturity on December 26.

Call Option on AOL Stock denote by ST the price of AOL stock on December 26 date scenario exercise option? Sep.125 receive stock  pay strike price  7 . 8 December 26 (if ST < 80) (if ST u 80) no yes     ST -80 cash flows (on per-share basis) pay option premium -7.

125 AOL stock price 60 70 80 90 100 on December 26 8 .Fang-bo Yeh Call Option on AOL Stock pay-off profit pay-off net profit 0 7.

Mathematics Finance 2003 Option Markets Maximal Losses and Gains on Option Positions long call maximal gain: unlimited maximal loss: premium long put maximal gain: strike minus premium maximal loss: premium short call maximal gain: premium maximal loss: unlimited short put maximal gain: premium maximal loss: strike minus premium Tunghai Mathematics 9 0 0 0 0 Fang-Bo Yeh .

Mathematics Finance 2003 Option Markets Simple Option Strategies: Covered Call ‡ covered call pay-offs: covered call: ‡ the potential loss on a short cash flows at maturity call position is unlimited case: ST < K ST u K ‡ the worst case occurs when Short call K-ST the stock price at maturity is long stock ST ST very high and the option is exercised total: ST K ‡ the easiest protection against ‡ Cost of strategy: this case is to buy the stock at the same time as you write you receive the option the option premium C while paying the stock price S this strategy is called the total cost is hence S-C ³covered call´ Fang-Bo Yeh Tunghai Mathematics 10 .

Mathematics Finance 2003 Option Markets Simple Option Strategies: Covered Call pay-off K short call profit premium + long stock 0 K ST = K Fang-Bo Yeh covered call Tunghai Mathematics 11 .

P the total cost is hence S+P Tunghai Mathematics 12 . you can purchase an at-the-money put option which allows you to sell the asset at a fixed price should its value decline this strategy is called ³protective put´ Fang-Bo Yeh ‡ protective put pay-offs: cash flows at maturity case: ST < K ST u K long stock ST ST long put K-ST total: K ST ‡ cost of strategy: the additional cost of protection is the price of the option. and you are worried about potential capital losses on your position ‡ to protect your position.Mathematics Finance 2003 Option Markets Simple Option Strategies: Protective Put protective put: ‡ suppose you have a long position in some asset.

Mathematics Finance 2003 Option Markets Simple Option Strategies: Protective Put pay-off long stock K + long put 0 premium K ST profit = K Fang-Bo Yeh protective put Tunghai Mathematics 13 .

ELKS 14 . Range Notes ‡ Bond + Forward (Swap) .Financial Engineering ‡ Bond + Single Option S&P500 Index Notes ‡ Bond + Multiple Option Floored Floating Rate Bonds.Structured Notes Inverse Floating Rate Note ‡ Stock + Option Equity-Linked Securities.

The expected value of the discounted future stochastic payoff (2). It is determined by market forces which is impossible have a theoretical price .Main Problem: What is the fair price for the contract? Ans: (1).

Main result: ‡ It is possible ‡ have a theoretical price which is consistent with the underlying prices given by the market ‡ But ‡ is not the same one as in answer (1). .

Methods Assume efficient market ‡ Risk neutral ‡ The elimination of valuation and solving randomness and conditional solving diffusion expectation of the equation random variable .

future pay-off Riskless bond B.Problem Formulation Contract F : Underlying asset S. return Future time T. St) . return dSt ! Q dt  W dZt St f(ST) dBt ! r dt Bt Find contract value F(t.

Deterministic Stochastic Differentiable Not differentiable .

Deterministic Function 20 .

Stochastic Brownian Motion t   t 21 .

From Calculus to Stochastic Calculus Calculus Differentiation Integration Stochastic Calculus Ito Differentiation Ito Integration Statistics Distribution Probability Stochastic Process Measure Equivalent Probability 22 .

St ) .ST ) then Tt ! F(t. Efficient market: (observable) If TT ! (T.Assume 1).Et ) such that Tt ! Ht St Et t dT t ! H t dSt  Et d t 2). The future pay-off is attainable: (controllable) exists a portfolio (H t .

) ! ¬  ­ xt x  xS 1 2 2 2 S dZ x d x x2 » dt  2 ¼ x ½ The Black-Scholes-Merton Equation: xF xF rS  xt xS 1 2 x 2F 2 2 !rF S 2 xS T (T. T )! ( ) .By assumptions (1)(2) dF(t. S) ! d S  d B ! [(  r) S  r F] dt  Ito¶s lemma «x d (t.

European Call Option Price: Fc ( t . S t ) ! S t N ( d 1 )  e  r ( T  t ) KN ( d 2 ) ln St K d1 !  ( r  1 W 2 )( T  t ) 2 W T t d 2 ! d1  W T  t .

Martingale Measure S ! e St . t T t* ! e rtT t dT t* ! H tWS *dZt* t dZ t* ! Q -r dt  dZ t ( P dt  dZ t W  Z t* ~ N p ( QW r t . t ) CMG Z t* p* (0. t ) Zt p (0. t ) Brownian Motion  PZ t  1 P2 t 2 Drift Brownian Motion E p* (Y ) ( E p (e Y) T t* ! E p* (T T* ) . * t  rt dSt* ! WS *dZt* .

St ) ! Tt ! er(T t ) Ep*[ f (ST )] ! erX Ep*[ f (ST )] Where dSt ! rdt  W dZ t* St St ! S0 e g ( r  1 W 2 ) t W Z t* 2 F(t.ertTt ! Ep*[ert f (ST )] F(t. 1) . x) ! erX ´ f (xe g (r  1W 2 )X WX 2 y 2 1 )N( y)dy N ~ N (0.

Main Result F(t. . St ) ! e r(T t ) Ep*[ f (ST )] The fair price is the expected value of the discounted future stochastic payoff under the new martingale measure.

From Real world to Martingale world Discounted Asset Price & Derivatives Price Under Real World Measure is not Martingale But Under Risk Neutral Measure is Martingale 29 .

Numerical Solution Methods Finite Difference ‡ Idea: Approximate differentials by simple differences via Taylor series Monte Carlo Simulation Idea: Monte Carlo Integration Generating and sampling Random variable 30 .

Introduction to Financial Mathematics (1) Topics for 2003: 1. 4. Risk Neutral Probability and Arbitrage Free Principal. Conditional Expectation and Martingales. Black-Scholes Model : PDE and Martingale and Ito¶s Calculus. 3. 2. 31 . Asset Pricing and Stochastic Process. 5. 6. Numerical method and Simulations. Pricing Model for Financial Engineering.

Hull . ‡ P. Rennie . Baxter. Kopp. 32 . ‡ R. Derivatives Securities. 2000. Elliott and P. Options. Jarrow and S. Southern College Publishing. Mathematics of Financial Markets.C. ‡ J. Financial Calculus. Springer Finance. Bingham and R. Risk Neutral Evaluation. 2001 ‡ N. 1999.References ‡ M. Derivatives.J. Prentice Hall.E.Cambridge university press. Wilmott. John Wiley and Sons.H. 1998 ‡ R. Kiesel . 2002. A. 1999. Springer Finance. Futures and other derivatives. Turnbull.

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