Exam MFE

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INTRODUCTION TO DERIVATIVES
INTRODUCTION TO DERIVATIVES
INTRODUCTION TO DERIVATIVES INTRODUCTION TO DERIVATIVES

Reasons for Using Derivatives

Reasons for Using Derivatives
Reasons for Using Derivatives Short-Selling
Short-Selling
Short-Selling Option Moneyness
Option Moneyness
Option Moneyness
••• Risk management – hedging
Risk management – hedging
Risk management – hedging ••• Borrow an asset from a lender
Borrow an asset from a lender
Borrow an asset from a lender ••• In-the-money: Produce a positive payoff (not
In-the-money: Produce a positive payoff (not
In-the-money: Produce a positive payoff (not
••• Speculation – to make a bet rather than to reduce
Speculation – to make a bet rather than to reduce
Speculation – to make a bet rather than to reduce ••• Immediately sell the borrowed asset and receive
Immediately sell the borrowed asset and receive
Immediately sell the borrowed asset and receive necessarily positive profit) if the option is
necessarily positive profit) if the option is
necessarily positive profit) if the option is
risk
risk
risk the proceeds (usually kept by lender or a
the proceeds (usually kept by lender or a
the proceeds (usually kept by lender or a exercised immediately
exercised immediately
exercised immediately
••• Reducing transaction cost
Reducing transaction cost
Reducing transaction cost designated 3
designated 3
designated 3 rd party)
rd party)
rd party) ••• At-the-money: The spot price is approximately
At-the-money: The spot price is approximately
At-the-money: The spot price is approximately
••• Minimizing taxes / avoiding regulatory issues
Minimizing taxes / avoiding regulatory issues
Minimizing taxes / avoiding regulatory issues ••• Buy the asset at a later date at the open market
Buy the asset at a later date at the open market
Buy the asset at a later date at the open market equal to the exercise price
equal to the exercise price
equal to the exercise price

to repay the lender (close/cover the short
to repay the lender (close/cover the short
to repay the lender (close/cover the short ••• Out-of-the-money: Produce a negative payoff if
Out-of-the-money: Produce a negative payoff if
Out-of-the-money: Produce a negative payoff if
Bid-ask Spread
Bid-ask Spread
Bid-ask Spread
position)
position)
position) the option is exercised immediately
the option is exercised immediately
the option is exercised immediately
Bid price: The price at which brokers will buy and
Bid price: The price at which brokers will buy and
Bid price: The price at which brokers will buy and
Haircut: Additional collateral placed with lender by
Haircut: Additional collateral placed with lender by
Haircut: Additional collateral placed with lender by
end-users will sell at.
end-users will sell at.
end-users will sell at. Option Style
Option Style
Option Style
short-seller. It belongs to the short-seller.
short-seller. It belongs to the short-seller.
short-seller. It belongs to the short-seller.
Ask/Offer price: The price at which brokers will sell
Ask/Offer price: The price at which brokers will sell
Ask/Offer price: The price at which brokers will sell ••• European-style options can only be exercised at
European-style options can only be exercised at
European-style options can only be exercised at
Interest rate on haircut is called:
Interest rate on haircut is called:
Interest rate on haircut is called:
and end-users will buy at.
and end-users will buy at.
and end-users will buy at. expiration.
expiration.
expiration.
••• short rebate in the stock market
short rebate in the stock market
short rebate in the stock market
Bid-ask spread = Ask price – Bid price
Bid-ask spread = Ask price – Bid price
Bid-ask spread = Ask price – Bid price ••• American-style options can be exercised at any
American-style options can be exercised at any
American-style options can be exercised at any
••• repo rate in the bond market
repo rate in the bond market
repo rate in the bond market
Round-trip transaction cost: difference between
Round-trip transaction cost: difference between
Round-trip transaction cost: difference between time during the life of the option.
time during the life of the option.
time during the life of the option.
Reasons for short-selling assets:
Reasons for short-selling assets:
Reasons for short-selling assets:
what you pay and what you receive from a sale
what you pay and what you receive from a sale
what you pay and what you receive from a sale ••• Bermudan-style options can be exercised during
Bermudan-style options can be exercised during
Bermudan-style options can be exercised during
••• Speculation – To speculate that the price of a
Speculation – To speculate that the price of a
Speculation – To speculate that the price of a
using the same set of bid/ask prices.
using the same set of bid/ask prices.
using the same set of bid/ask prices. bounded periods (i.e. specified periods during the
bounded periods (i.e. specified periods during the
bounded periods (i.e. specified periods during the
particular asset will decline.
particular asset will decline.
particular asset will decline.
Long vs. Short
Long vs. Short
Long vs. Short life of the option).
life of the option).
life of the option).
••• Financing – To borrow money for additional
Financing – To borrow money for additional
Financing – To borrow money for additional
A long position in an asset benefits from an increase
A long position in an asset benefits from an increase
A long position in an asset benefits from an increase
financing of a corporation.
financing of a corporation.
financing of a corporation.
in the price of the asset.
in the price of the asset.
in the price of the asset. Zero-coupon Bond
Zero-coupon Bond
Zero-coupon Bond
••• Hedging – To hedge the risk of owning an asset
Hedging – To hedge the risk of owning an asset
Hedging – To hedge the risk of owning an asset
A short position in an asset benefits from a decrease
A short position in an asset benefits from a decrease
A short position in an asset benefits from a decrease Buying zero-coupon bond = lending money
Buying zero-coupon bond = lending money
Buying zero-coupon bond = lending money
or a derivative on the asset.
or a derivative on the asset.
or a derivative on the asset.
Selling zero-coupon bond = borrowing money
Selling zero-coupon bond = borrowing money
Selling zero-coupon bond = borrowing money
in the price of the asset.
in the price of the asset.
in the price of the asset.
Profit on the bond = 0
Profit on the bond = 0
Profit on the bond = 0


FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS
FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS
FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS
FORWARD CONTRACTS, CALL OPTIONS, AND PUT OPTIONS

Position
Position
Position Position in
Position in
Position in Maximum
Maximum
Maximum Maximum
Maximum
Maximum
Contract
Contract
Contract Description
Description
Description Payoff
Payoff
Payoff Profit
Profit
Profit Strategy
Strategy
Strategy
in Contract
in Contract
in Contract Underlying
Underlying
Underlying Loss
Loss
Loss Gain
Gain
Gain
Obligation to
Obligation to
Obligation to Guarantee/lock in
Guarantee/lock in
Guarantee/lock in
Long Forward
Long Forward
Long Forward buy at the
buy at the
buy at the Long
Long
Long 𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐹𝐹𝐹𝐹%,"
𝐹𝐹%," 𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐹𝐹𝐹𝐹%,"
𝐹𝐹%," −𝐹𝐹
−𝐹𝐹
−𝐹𝐹 ∞
∞
∞ purchase price of
purchase price of
purchase price of
Forward
Forward
Forward

%," %," %,"

%,"
%,"
forward price
forward price
forward price underlying
underlying
underlying
Obligation to sell
Obligation to sell
Obligation to sell Guarantee/lock in
Guarantee/lock in
Guarantee/lock in
Short Forward
Short Forward
Short Forward at the forward
at the forward
at the forward Short
Short
Short 𝐹𝐹𝐹𝐹%,"
𝐹𝐹%,"
%,"−
−−𝑆𝑆𝑆𝑆"𝑆𝑆" " 𝐹𝐹𝐹𝐹%,"
𝐹𝐹%,"
%,"−
−−𝑆𝑆𝑆𝑆"𝑆𝑆" " −∞
−∞
−∞ 𝐹𝐹𝐹𝐹%,"
𝐹𝐹%,"
%," sale price of
sale price of
sale price of
price
price
price underlying
underlying
underlying
Right (but not
Right (but not
Right (but not
Insurance against
Insurance against
Insurance against
obligation) to
obligation) to
obligation) to max [0,
max [0,
max [0,𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐾𝐾]
𝐾𝐾]
𝐾𝐾]
Long Call
Long Call
Long Call Long
Long
Long max [0,
max [0,
max [0,𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐾𝐾]
𝐾𝐾]
𝐾𝐾] −𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.) ) ) ∞
∞
∞ high underlying
high underlying
high underlying
buy at the strike
buy at the strike
buy at the strike −−−𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) )
price
price
price
price
price
price
Call
Call
Call

Obligation to sell
Obligation to sell
Obligation to sell Sells insurance
Sells insurance
Sells insurance
at the strike
at the strike
at the strike −max [0,
−max [0,
−max [0,𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐾𝐾]
𝐾𝐾]
𝐾𝐾] against
against
against
Short Call
Short Call
Short Call Short
Short
Short −max [0,
−max [0,
−max [0,𝑆𝑆𝑆𝑆"𝑆𝑆""−−−𝐾𝐾]
𝐾𝐾]
𝐾𝐾] −∞
−∞
−∞ 𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) )
price if the call
price if the call
price if the call +++𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) ) high underlying
high underlying
high underlying
is exercised
is exercised
is exercised price
price
price
Right (but not
Right (but not
Right (but not
Insurance against
Insurance against
Insurance against
obligation) to
obligation) to
obligation) to max [0,
max [0,
max [0,𝐾𝐾𝐾𝐾𝐾𝐾−−−𝑆𝑆𝑆𝑆"𝑆𝑆"]"]] 𝐾𝐾
𝐾𝐾
𝐾𝐾
Long Put
Long Put
Long Put Short
Short
Short max [0,
max [0,
max [0,𝐾𝐾𝐾𝐾𝐾𝐾−−−𝑆𝑆𝑆𝑆"𝑆𝑆"] "] ] −𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.) ) ) low underlying
low underlying
low underlying
sell at the strike
sell at the strike
sell at the strike −−−𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) ) −𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.
−𝐹𝐹𝐹𝐹(Prem.) ) )
price
price
price
price
price
price
Put
Put
Put

Obligation to
Obligation to
Obligation to Sells insurance
Sells insurance
Sells insurance
buy at the strike
buy at the strike
buy at the strike −−−max
max
max0,0,0,𝐾𝐾𝐾𝐾𝐾𝐾−−−𝑆𝑆𝑆𝑆"𝑆𝑆"" 𝐹𝐹𝐹𝐹
𝐹𝐹𝐹𝐹
𝐹𝐹𝐹𝐹Prem.
Prem.
Prem. against
against
against
Short Put
Short Put
Short Put Long
Long
Long −max [0,
−max [0,
−max [0,𝐾𝐾𝐾𝐾𝐾𝐾−−−𝑆𝑆𝑆𝑆"𝑆𝑆"] "] ] 𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) )
price if the put
price if the put
price if the put +++𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.
𝐹𝐹𝐹𝐹(Prem.) ) ) −𝐾𝐾
−𝐾𝐾
−𝐾𝐾 low underlying
low underlying
low underlying
is exercised
is exercised
is exercised price
price
price
Forward
Forward
Forward Call
Call
Call Put
Put
Put
FF0,T
F0,T0,T
rrddrd LLoLoo
wwawaa lllll
CCaCaa nngngg
ggFgFoForor r nngngg PPuPutut t
nn
LLoLoo
n LLoLoo
Payoff
Payoff
Payoff

Payoff
Payoff
Payoff

Payoff
Payoff
Payoff

000 000 000

SShShohoo SShShohoo
rrt trFtFF rrttrCtCC tt t
aallalll PPuPuu
oororww
rawaa
rrddrd hhohorort trt
SSS
--F
-F0,T
F0,T0,T
FF0,T
F0,T0,T KKK KKK
Spot
Spot
SpotPrice
Price
PriceatatatExpiration
Expiration
Expiration Spot
Spot
SpotPrice
Price
PriceatatatExpiration
Expiration
Expiration Spot
Spot
SpotPrice
Price
PriceatatatExpiration
Expiration
Expiration

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 OPTIONS COMBINATION
OPTIONS COMBINATION

Put-Call Parity
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 = 𝑃𝑃𝑃𝑃 𝐹𝐹%," − 𝑃𝑃𝑃𝑃 𝐾𝐾

By rearranging put-call parity:
• Floor = Stock + Put
• Write a covered put = – Stock – Put
• Cap = Call – Stock
• Write a covered call = – Call + Stock

Synthetic Forward Bull Spread Bear Spread
Syn. Long forw. = Long call (K) + Short put (K) • Long call (K1) + Short call (K2), K1 < K2 • Short call (K1) + Long call (K2), K1 < K2
Syn. Short forw. = Short call (K) + Long put (K) • Long put (K1) + Short put (K2), K1 < K2 • Short put (K1) + Long put (K2), K1 < K2
F0,T Bull Spread Bear Spread
rd
or wa
n gF
Lo
Payoff

Payoff

Payoff
0
Sho
rt F
orw
ard
- F0,T
F0,T K1 K2 K1 K2
Spot Price at Expiration Spot Price at Expiration Spot Price at Expiration

Box Spread Ratio Spread Collar
Synthetic long forward (K1) + Synthetic short Long and short an unequal number of calls/puts Long put (K1) + Short call (K2), K1 < K2
forward (K2), K1 < K2 with different strike prices
Collar
Box Spread Ratio Spread

K2 - K1

Payoff
0
Payoff
Payoff

0 0

K1 K2
Spot Price at Expiration
Spot Price at Expiration
Spot Price at Expiration


Collared Stock Strangle Straddle
Long collar + Long stock Long put (K1) + Long call (K2), K1 < K2 Long put (K) + Long call (K)
Collared Stock Strangle Straddle
Payoff
Payoff

0 0
Payoff

K1 K2 K
Spot Price at Expiration Spot Price at Expiration

Spot Price at Expiration

Butterfly Spread
Butterfly Spread
Buy high and low-strike options. Sell middle-strike option.
Quantity sold = Quantity bought.

Symmetric
Payoff

• 1 * Long call (K1) + 2 * Short call (K2) + 1 * Long call (K3), K1 < K2 < K3
• 1 * Long put (K1) + 2 * Short put (K2) + 1 * Long put (K3), K1 < K2 < K3

Asymmetric
𝐾𝐾= − 𝐾𝐾>
𝜆𝜆 =
𝐾𝐾= − 𝐾𝐾?
Spot Price at Expiration
• 𝜆𝜆 * Long call (K1) + 1 * Short call (K2) + 1 − 𝜆𝜆 * Long call (K3), K1 < K2 < K3
• 𝜆𝜆 * Long put (K1) + 1 * Short put (K2) + 1 − 𝜆𝜆 * Long put (K3), K1 < K2 < K3

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FINANCIAL FORWARDS AND FUTURES
FINANCIAL FORWARDS AND FUTURES Margin Call Different Strike Prices

Maintenance margin: minimum margin balance For 𝐾𝐾? ≤ 𝐾𝐾> ≤ 𝐾𝐾= :
4 Ways to Buy a Share of Stock
that the investor is required to maintain in margin Call
Pay Receive • 𝐶𝐶 𝐾𝐾? ≥ 𝐶𝐶 𝐾𝐾> ≥ 𝐶𝐶 𝐾𝐾=
Ways At Stock Payment account at all times
• 𝐶𝐶 𝐾𝐾? − 𝐶𝐶 𝐾𝐾> ≤ 𝐾𝐾> − 𝐾𝐾?
Time at Time Margin call: if the margin balance falls below the
European: 𝐶𝐶 𝐾𝐾? − 𝐶𝐶 𝐾𝐾> ≤ 𝑃𝑃𝑃𝑃 𝐾𝐾> − 𝐾𝐾?
Outright maintenance margin, then the investor will get a à âä Tà âã à â Tà âå
0 0 𝑆𝑆% • ≥ ã
purchase request for an additional margin deposit. The âã Tâä âå Tâã

Fully investor has to add more fund to bring the margin Put
leveraged T 0 𝑆𝑆% 𝑒𝑒 B" • 𝑃𝑃 𝐾𝐾? ≤ 𝑃𝑃 𝐾𝐾> ≤ 𝑃𝑃(𝐾𝐾= )
balance back to the initial margin.
purchase • 𝑃𝑃 𝐾𝐾> − 𝑃𝑃 𝐾𝐾? ≤ 𝐾𝐾> − 𝐾𝐾?

Prepaid European: 𝑃𝑃 𝐾𝐾> − 𝑃𝑃 𝐾𝐾? ≤ 𝑃𝑃𝑃𝑃 𝐾𝐾> − 𝐾𝐾?
0 T D
𝐹𝐹C," 𝑆𝑆 D âã TD âä D â TD(âã )
forward • ≤ å
PUT-CALL PARITY (PCP)
PUT-CALL PARITY (PCP) âã Tâä âå Tâã
contract

Forward T T 𝐹𝐹C," 𝑆𝑆 PCP for Stock
contract D
𝐶𝐶 𝑆𝑆, 𝐾𝐾 − 𝑃𝑃 𝑆𝑆, 𝐾𝐾 = 𝐹𝐹C," 𝑆𝑆 − 𝐾𝐾𝑒𝑒 TB("TC)

BINOMIAL MODEL
BINOMIAL MODEL
PCP for Exchange Option

Relationship between 𝑭𝑭𝒕𝒕,𝑻𝑻 𝑺𝑺 and 𝑭𝑭𝑷𝑷𝒕𝒕,𝑻𝑻 𝑺𝑺 Replicating Portfolio

𝑪𝑪 𝑨𝑨, 𝑩𝑩 𝑷𝑷 𝑨𝑨, 𝑩𝑩
D An option can be replicated by buying Δ shares
𝐹𝐹C," 𝑆𝑆 = Accumulated Value of 𝐹𝐹C," 𝑆𝑆 receive 𝐴𝐴, give up 𝐵𝐵 give up 𝐴𝐴, receive 𝐵𝐵
D D of the underlying stock and lending 𝐵𝐵 at the
D
= 𝐹𝐹C," 𝑆𝑆 ⋅ 𝑒𝑒 B("TC) 𝐶𝐶(𝐴𝐴, 𝐵𝐵) − 𝑃𝑃(𝐴𝐴, 𝐵𝐵) = 𝐹𝐹C," 𝐴𝐴 − 𝐹𝐹C," 𝐵𝐵
risk-free rate.
𝐶𝐶 𝐴𝐴, 𝐵𝐵 = 𝑃𝑃 𝐵𝐵, 𝐴𝐴 𝑉𝑉É − 𝑉𝑉p 𝑢𝑢𝑉𝑉p − 𝑑𝑑𝑉𝑉É
Δ = 𝑒𝑒 TY` 𝐵𝐵 = 𝑒𝑒 TB`
Dividend Structure 𝑭𝑭𝑷𝑷𝒕𝒕,𝑻𝑻 (𝑺𝑺) PCP for Currency Exchange 𝑆𝑆 𝑢𝑢 − 𝑑𝑑 𝑢𝑢 − 𝑑𝑑
𝑆𝑆% → 𝑥𝑥% 𝑟𝑟 → 𝑟𝑟p 𝛿𝛿 → 𝑟𝑟r 𝑉𝑉 = Δ𝑆𝑆 + 𝐵𝐵
None 𝑆𝑆C
𝐶𝐶p 𝑓𝑓, 𝐾𝐾 − 𝑃𝑃p 𝑓𝑓, 𝐾𝐾 = 𝑥𝑥% 𝑒𝑒 TBt " − 𝐾𝐾𝑒𝑒 TBu "
Discrete 𝑆𝑆C − PV(Divs) 1 Call Put
Continuous 𝑆𝑆C 𝑒𝑒 TY("TC) 𝐶𝐶p 𝑓𝑓, 𝐾𝐾 = 𝑃𝑃p 𝐾𝐾, 𝑓𝑓 = 𝑥𝑥% ⋅ 𝐾𝐾 ⋅ 𝑃𝑃r 𝑑𝑑, Δ + −
𝐾𝐾

where 𝑥𝑥% is in 𝑑𝑑/𝑓𝑓 𝐵𝐵 − +
Dividend Structure 𝑭𝑭𝒕𝒕,𝑻𝑻 (𝑺𝑺)

PCP for Bonds Risk-neutral Probability Pricing

None 𝑆𝑆C 𝑒𝑒 B("TC) D
𝐶𝐶 − 𝑃𝑃 = 𝐹𝐹C," 𝐵𝐵 − 𝐾𝐾𝑒𝑒 TB("TC) 𝑒𝑒 BTY ` − 𝑑𝑑
Discrete 𝑆𝑆C 𝑒𝑒 B "TC
− AV Divs 𝑝𝑝∗ =
where 𝑢𝑢 − 𝑑𝑑
Continuous 𝑆𝑆C 𝑒𝑒 (BTY) "TC
D
𝐹𝐹C," 𝐵𝐵 = 𝐵𝐵C − 𝑃𝑃𝑉𝑉C," 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑉𝑉 = 𝑒𝑒 TB` 𝑝𝑝∗ 𝑉𝑉É + 1 − 𝑝𝑝∗ 𝑉𝑉p

𝐵𝐵C = Bond price at time 𝑡𝑡 𝑆𝑆% 𝑒𝑒 BTY ` = 𝑝𝑝∗ 𝑆𝑆É + 1 − 𝑝𝑝∗ 𝑆𝑆p
𝐹𝐹%," 𝑆𝑆
Forward premium = Realistic/True Probability Pricing
𝑆𝑆%
𝑒𝑒 èTY ` − 𝑑𝑑
1 𝐹𝐹%," 𝑆𝑆 𝑝𝑝 =
Annualized forward premium rate = ln COMPARING OPTIONS
COMPARING OPTIONS 𝑢𝑢 − 𝑑𝑑
𝑇𝑇 𝑆𝑆%
𝑉𝑉 = 𝑒𝑒 Tê` 𝑝𝑝 𝑉𝑉É + 1 − 𝑝𝑝 𝑉𝑉p
Bounds for Option Prices
𝑆𝑆% 𝑒𝑒 èTY ` = 𝑝𝑝 𝑆𝑆É + 1 − 𝑝𝑝 𝑆𝑆p
Arbitrage Call and Put Δ𝑆𝑆 è` 𝐵𝐵 B`
𝑆𝑆 ≥ 𝐶𝐶ÄÅB ≥ 𝐶𝐶ÇÉB ≥ max 0, 𝐹𝐹 D 𝑆𝑆 − 𝐾𝐾𝑒𝑒 TB" 𝑒𝑒 ê` = 𝑒𝑒 + 𝑒𝑒
A transaction which generates a positive cash flow 𝑉𝑉 𝑉𝑉
𝐾𝐾 ≥ 𝑃𝑃ÄÅB ≥ 𝑃𝑃ÇÉB ≥ max 0, 𝐾𝐾𝑒𝑒 TB" − 𝐹𝐹 D 𝑆𝑆
either today or in the future by simultaneous

buying and selling of related assets, with no net European vs. American Call Standard Binomial Tree (Forward Tree)
investment or risk. 𝐹𝐹 D 𝑆𝑆 ≥ 𝐶𝐶ÇÉB ≥ max 0, 𝐹𝐹 D 𝑆𝑆 − 𝐾𝐾𝑒𝑒 TB" 𝑢𝑢 = 𝑒𝑒 BTY `ëí ` 𝑑𝑑 = 𝑒𝑒 BTY `Tí `
Arbitrage strategy: “Buy Low, Sell High.” 𝑆𝑆 ≥ 𝐶𝐶ÄÅB ≥ max (0, 𝑆𝑆 − 𝐾𝐾) 𝑒𝑒 BTY ` − 𝑑𝑑 1
European vs. American Put 𝑝𝑝∗ = =

𝑢𝑢 − 𝑑𝑑 1 + 𝑒𝑒 í `
𝐾𝐾𝑒𝑒 TB" ≥ 𝑃𝑃ÇÉB ≥ max 0, 𝐾𝐾𝑒𝑒 TB" − 𝐹𝐹 D 𝑆𝑆

Cash-and-Carry 𝐾𝐾 ≥ 𝑃𝑃ÄÅB ≥ max (0, 𝐾𝐾 − 𝑆𝑆) Cox-Ross-Rubinstein Tree

Lend cash by buying the asset and shorting a
𝑢𝑢 = 𝑒𝑒 í ` 𝑑𝑑 = 𝑒𝑒 Tí `
forward

Early Exercise of American Option Lognormal Tree (Jarrow-Rudd Tree)
American Call ã ã
𝑢𝑢 = 𝑒𝑒 BTYT%.ìí `ëí ` 𝑑𝑑 = 𝑒𝑒 BTYT%.ìí `Tí `
Reverse Cash-and-Carry • Nondividend-paying stock
Borrow cash by selling the asset and longing a o Early exercise is never optimal. Probability
forward o 𝐶𝐶ÄÅB = 𝐶𝐶ÇÉB The probability of reaching the i-th node from the
• Dividend-paying stock top of an n-period binomial tree is:
Futures Compared to Forward 𝑛𝑛 ïTñ
o Early exercise is not optimal if 𝑝𝑝 1 − 𝑝𝑝 ñ
• Traded on an exchange 𝑃𝑃𝑃𝑃 Dividends < 𝑖𝑖

• Standardized (size, expiration, underlying) 𝑃𝑃𝑃𝑃 Interest on the strike + Implicit Put No-Arbitrage Condition
• More liquid American Put Arbitrage is possible if the following inequality is
• Marked-to-market and settled daily Early exercise is not optimal if not satisfied:
• Minimal credit risk 𝑃𝑃𝑃𝑃 Interest on the strike < 0 < 𝑝𝑝∗ < 1 ⟺ 𝑑𝑑 < 𝑒𝑒 BTY ` < 𝑢𝑢
• Price limit 𝑃𝑃𝑃𝑃 Dividends + Implicit Call

Option on Currencies

𝑆𝑆% → 𝑥𝑥% 𝑟𝑟 → 𝑟𝑟p 𝛿𝛿 → 𝑟𝑟r
Margin Balance
𝑢𝑢 = 𝑒𝑒 Bu TBt `ëí ` 𝑑𝑑 = 𝑒𝑒 Bu TBt `Tí `

Balt = BaltT? ⋅ 𝑒𝑒 B` + Gainb
𝑒𝑒 Bu TBt ` − 𝑑𝑑
where 𝑝𝑝∗ =
𝑢𝑢 − 𝑑𝑑
• Gainb = Multipler ×Price Changet

• Price Changet = Future Priceb − Future PricebT?

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Option on Futures Contracts BLACK-SCHOLES PRICING MODEL
BLACK-SCHOLES PRICING MODEL Gamma
𝐹𝐹C,"ò = 𝑆𝑆C 𝑒𝑒 (BTY)("ò TC) ø¿¡¬√ƒ ≈¬ ”ƒ‘b¡ Œ’ Œãœ
Generalized B-S Formula • Γ= = =
ø¿¡¬√ƒ ≈¬ Ãb»ÀÕ … ≈Àƒ Œ– Œ– ã
𝑇𝑇 = Expiration date of the option 𝐶𝐶 = 𝐹𝐹 D 𝑆𝑆 ⋅ 𝑁𝑁 𝑑𝑑? − 𝐹𝐹 D 𝐾𝐾 ⋅ 𝑁𝑁 𝑑𝑑> • Γà ≥ 0 ΓD ≥ 0
𝑇𝑇ö = Expiration date of the futures contract 𝑃𝑃 = 𝐹𝐹 D 𝐾𝐾 ⋅ 𝑁𝑁 −𝑑𝑑> − 𝐹𝐹 D 𝑆𝑆 ⋅ 𝑁𝑁 −𝑑𝑑? ƒ÷« T%.ìpäã
𝑇𝑇 ≤ 𝑇𝑇ö • Γà = ΓD = 𝑒𝑒 TY "TC
⋅
𝐹𝐹 D 𝑆𝑆 1 –í >◊ "TC
𝑆𝑆C → 𝐹𝐹C,"ò 𝛿𝛿 → 𝑟𝑟 ln D + 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 uã
𝐹𝐹 𝐾𝐾 2 ⁄ Ÿ
1 − 𝑑𝑑ö 𝑉𝑉É − 𝑉𝑉p 𝑑𝑑? = Œÿ pŸ Å ã
𝑝𝑝∗ = Δ = 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 • =
Œ– –í >◊"
𝑢𝑢ö − 𝑑𝑑ö 𝐹𝐹 𝑢𝑢ö − 𝑑𝑑ö
TB` ∗ ∗ 𝐹𝐹 D 𝑆𝑆 1 Theta
𝐵𝐵 = 𝑒𝑒 𝑝𝑝 𝑉𝑉É + 1 − 𝑝𝑝 𝑉𝑉p ln D − 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡
𝐹𝐹 𝐾𝐾 2 • 𝜃𝜃 = Change in the option price
𝑑𝑑> = = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
𝜎𝜎 𝑇𝑇 − 𝑡𝑡 as time advances
𝒓𝒓, 𝜶𝜶, 𝜸𝜸𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 , 𝜸𝜸𝑷𝑷𝑷𝑷𝑷𝑷
Œœ
=
𝛾𝛾DÉC ≤ 𝑟𝑟 ≤ 𝛼𝛼 ≤ 𝛾𝛾ࣧ§ B-S Formula for Stock ŒC
• 𝜃𝜃 is usually negative.
𝐶𝐶 = 𝑆𝑆C 𝑒𝑒 TY "TC ⋅ 𝑁𝑁 𝑑𝑑? − 𝐾𝐾𝑒𝑒 TB "TC ⋅ 𝑁𝑁 𝑑𝑑>
• 𝜃𝜃à = 𝛿𝛿𝛿𝛿𝑒𝑒 TY("TC) 𝑁𝑁 𝑑𝑑? − 𝑟𝑟𝑟𝑟𝑒𝑒 TB "TC
𝑁𝑁 𝑑𝑑> −
𝑃𝑃 = 𝐾𝐾𝑒𝑒 TB "TC ⋅ 𝑁𝑁 −𝑑𝑑> − 𝑆𝑆C 𝑒𝑒 TY "TC ⋅ 𝑁𝑁 −𝑑𝑑?
âÅ ⁄‹ ›⁄fi ÿ fl pã í
LOGNORMAL MODEL LOGNORMAL MODEL 𝑆𝑆 1
ln C + 𝑟𝑟 − 𝛿𝛿 + 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 > "TC

𝑑𝑑? = 𝐾𝐾 2 • 𝜃𝜃à − 𝜃𝜃D = 𝛿𝛿𝛿𝛿𝑒𝑒 TY "TC − 𝑟𝑟𝑟𝑟𝑒𝑒 TB "TC
Lognormal Model for Stock Prices 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
𝑋𝑋~𝑁𝑁 𝑚𝑚, 𝑣𝑣 > ⟺ 𝑌𝑌 = 𝑒𝑒 ´ ~𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑚𝑚, 𝑣𝑣 > Vega
𝑆𝑆 1 ø¿¡¬√ƒ ≈¬ ∆«b≈»¬ … ≈Àƒ Œœ
• 𝐸𝐸 𝑌𝑌 = 𝑒𝑒 Äë%.ìØ
ã ln C + 𝑟𝑟 − 𝛿𝛿 − 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 • Vega = =
𝑑𝑑> = 𝐾𝐾 2 ø¿¡¬√ƒ ≈¬ ‡»‘¡b≈‘≈b· Œí
ã
• 𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 = 𝐸𝐸 𝑌𝑌 > 𝑒𝑒 Ø − 1 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 • Vegaà ≥ 0 VegaD ≥ 0
𝑆𝑆" = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 • Vegaà = VegaD = 𝑆𝑆𝑒𝑒 TY "TC 𝑁𝑁 ‚ 𝑑𝑑? 𝑇𝑇 − 𝑡𝑡
For 𝑇𝑇 > 𝑡𝑡, ln ~𝑁𝑁 𝑚𝑚, 𝑣𝑣 >
𝑆𝑆C Rho
• 𝑚𝑚 = 𝛼𝛼 − 𝛿𝛿 − 0.5𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 B-S Formula for Currency • 𝜌𝜌 =
ø¿¡¬√ƒ ≈¬ ∆«b≈»¬ … ≈Àƒ Œœ
=
ø¿¡¬√ƒ ≈¬ ‰≈—ÕT ƒƒ  ¡bƒ ŒB
• 𝑣𝑣 > = 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 𝑆𝑆C → 𝑥𝑥C 𝑟𝑟 → 𝑟𝑟p 𝛿𝛿 → 𝑟𝑟r
• 𝜌𝜌à ≥ 0 𝜌𝜌D ≤ 0
𝐸𝐸 𝑆𝑆" = 𝑆𝑆C 𝑒𝑒 (èTY)("TC) 𝐶𝐶 = 𝑥𝑥C 𝑒𝑒 TBt "TC ⋅ 𝑁𝑁 𝑑𝑑? − 𝐾𝐾𝑒𝑒 TBu "TC ⋅ 𝑁𝑁 𝑑𝑑>
• 𝜌𝜌à = 𝑇𝑇 − 𝑡𝑡 𝐾𝐾𝑒𝑒 TB "TC 𝑁𝑁 𝑑𝑑>
ã
𝐸𝐸 𝑆𝑆" £ = 𝑆𝑆C £ 𝑒𝑒 £ èTY ë%.ì£ £T? í "TC 𝑃𝑃 = 𝐾𝐾𝑒𝑒 TBu "TC ⋅ 𝑁𝑁 −𝑑𝑑> − 𝑥𝑥C 𝑒𝑒 TBt "TC ⋅ 𝑁𝑁 −𝑑𝑑?
ã 𝑥𝑥 1 • 𝜌𝜌D = − 𝑇𝑇 − 𝑡𝑡 𝐾𝐾𝑒𝑒 TB "TC 𝑁𝑁 −𝑑𝑑>
𝑉𝑉𝑉𝑉𝑉𝑉 𝑆𝑆" = 𝐸𝐸 𝑆𝑆" > 𝑒𝑒 Ø − 1 ln C + 𝑟𝑟p − 𝑟𝑟r + 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 Psi
ã 𝑑𝑑? = 𝐾𝐾 2
𝑆𝑆" = 𝑆𝑆C 𝑒𝑒 èTYT%.ìí "TC ëí "TC⋅¥ , 𝑍𝑍~𝑁𝑁(0,1) 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 • 𝜓𝜓 =
ø¿¡¬√ƒ ≈¬ ∆«b≈»¬ … ≈Àƒ
=
Œœ
ã ø¿¡¬√ƒ ≈¬ ”≈Á≈˃¬Ë È≈ƒ‘Ë ŒY
Median = 𝑆𝑆C 𝑒𝑒 èTYT%.ìí "TC 𝑥𝑥 1
ln C + 𝑟𝑟p − 𝑟𝑟r − 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 • 𝜓𝜓à ≤ 0 𝜓𝜓D ≥ 0
𝑑𝑑> = 𝐾𝐾 2 • 𝜓𝜓à = − 𝑇𝑇 − 𝑡𝑡 𝑆𝑆𝑒𝑒 TY "TC 𝑁𝑁 𝑑𝑑?
Covariance
𝑆𝑆" 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 • 𝜓𝜓D = 𝑇𝑇 − 𝑡𝑡 𝑆𝑆𝑒𝑒 TY "TC 𝑁𝑁 −𝑑𝑑?
𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆C , 𝑆𝑆" = 𝐸𝐸 ⋅ 𝑉𝑉𝑎𝑎𝑎𝑎 𝑆𝑆C 𝑆𝑆% = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
𝑆𝑆C

Elasticity
Probability B-S Formula for Futures % change in option price Δ𝑆𝑆
Pr 𝑆𝑆" < 𝐾𝐾 = 𝑁𝑁 −𝑑𝑑> Pr 𝑆𝑆" > 𝐾𝐾 = 𝑁𝑁 +𝑑𝑑> 𝐹𝐹C,"ò = 𝑆𝑆C 𝑒𝑒 (BTY)("ò TC) Ω= =
% change in stock price 𝑉𝑉
𝑆𝑆 𝑇𝑇 = Expiration date of the option
ln C + (𝛼𝛼 − 𝛿𝛿 − 0.5𝜎𝜎 > )(𝑇𝑇 − 𝑡𝑡) Ωࣧ§ ≥ 1 ΩDÉC ≤ 0
𝑑𝑑> = 𝐾𝐾 𝑇𝑇ö = Expiration date of the futures contract
𝜎𝜎 𝑇𝑇 − 𝑡𝑡 𝑇𝑇 ≤ 𝑇𝑇ö

Risk Premium
𝑆𝑆C → 𝐹𝐹C,"ò 𝛿𝛿 → 𝑟𝑟 𝛾𝛾 − 𝑟𝑟 = Ω(𝛼𝛼 − 𝑟𝑟)
Prediction Interval (Confidence Interval)
The (1 − 𝑝𝑝) prediction interval is given by 𝑆𝑆"∂ and 𝐶𝐶 = 𝐹𝐹C,"ò 𝑒𝑒 TB "TC ⋅ 𝑁𝑁 𝑑𝑑? − 𝐾𝐾𝑒𝑒 TB "TC ⋅ 𝑁𝑁 𝑑𝑑> 𝜎𝜎ÏÌCñÓï = Ω 𝜎𝜎–CÓÔ
𝑆𝑆"∑ such that Pr 𝑆𝑆"∂ < 𝑆𝑆" < 𝑆𝑆"∑ = 1 − 𝑝𝑝. 𝑃𝑃 = 𝐾𝐾𝑒𝑒 TB "TC ⋅ 𝑁𝑁 −𝑑𝑑> − 𝐹𝐹C,"ò 𝑒𝑒 TB "TC ⋅ 𝑁𝑁 −𝑑𝑑?
ã
𝑆𝑆"∂ = 𝑆𝑆C 𝑒𝑒 èTYT%.ìí "TC ëí "TC⋅∏
π 𝐹𝐹C,"ò 1 Sharpe Ratio
ln + 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡 Risk premium 𝛼𝛼 − 𝑟𝑟
∑ èTYT%.ìí ã "TC ëí "TC⋅∏ ∫ 𝐾𝐾 2
𝑆𝑆" = 𝑆𝑆C 𝑒𝑒 𝑑𝑑? = 𝜙𝜙ÚCÓÔ = =
𝑝𝑝 𝑝𝑝 𝜎𝜎 𝑇𝑇 − 𝑡𝑡 volatility 𝜎𝜎ÚCÓÔ
Pr 𝑍𝑍 < 𝑧𝑧 ∂ = ⇒ 𝑧𝑧 ∂ = 𝑁𝑁 T?
2 2 𝐹𝐹C,"ò 1 𝜙𝜙Ô£§§ = 𝜙𝜙ÚCÓÔ 𝜙𝜙ÌÉC = −𝜙𝜙ÚCÓÔ
𝑝𝑝 ln − 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡
𝑧𝑧 ∑ = −𝑧𝑧 ∂ = −𝑁𝑁 T? 𝐾𝐾 2
2 𝑑𝑑> = = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
𝜎𝜎 𝑇𝑇 − 𝑡𝑡

Portfolio Greek & Elasticity
Conditional and Partial Expectation
Greek for portfolio = sum of the Greeks
𝑃𝑃𝑃𝑃 𝑆𝑆" 𝑆𝑆" < 𝐾𝐾 Volatility
𝐸𝐸 𝑆𝑆" 𝑆𝑆" < 𝐾𝐾 = Elasticity for a portfolio = weighted average of the
Pr 𝑆𝑆" < 𝐾𝐾 𝑉𝑉𝑉𝑉𝑉𝑉 ln 𝑆𝑆(𝑡𝑡) elasticities
èTY "TC 𝜎𝜎 = , 0 < 𝑡𝑡 ≤ 𝑇𝑇 ï
𝑆𝑆C 𝑒𝑒 𝑁𝑁 −𝑑𝑑? 𝑡𝑡 ΔDÓBCrÓ§ñÓ ⋅ 𝑆𝑆
= ΩDÓBCrÓ§ñÓ = = 𝜔𝜔ñ Ωñ
𝑁𝑁 −𝑑𝑑> 𝑉𝑉DÓBCrÓ§ñÓ
𝑃𝑃𝑃𝑃 𝑆𝑆" 𝑆𝑆" > 𝐾𝐾 𝑉𝑉𝑉𝑉𝑉𝑉 ln 𝐹𝐹C," (𝑆𝑆) ñı?
𝐸𝐸 𝑆𝑆" 𝑆𝑆" > 𝐾𝐾 = = , 0 < 𝑡𝑡 ≤ 𝑇𝑇 𝛾𝛾DÓBCrÓ§ñÓ − 𝑟𝑟 = ΩDÓBCrÓ§ñÓ (𝛼𝛼 − 𝑟𝑟)
Pr 𝑆𝑆" > 𝐾𝐾 𝑡𝑡
𝑆𝑆C 𝑒𝑒 èTY "TC 𝑁𝑁 +𝑑𝑑?
D
= 𝑉𝑉𝑉𝑉𝑉𝑉 ln 𝐹𝐹C," (𝑆𝑆)
𝑁𝑁 +𝑑𝑑> = , 0 < 𝑡𝑡 ≤ 𝑇𝑇 Implied vs. Historical Volatility
𝑡𝑡
𝑆𝑆 Implied volatility: start with option prices and a
ln C + 𝛼𝛼 − 𝛿𝛿 + 0.5𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡

𝑑𝑑? = 𝐾𝐾 Greeks pricing model. Back out the volatility from the
𝜎𝜎 𝑇𝑇 − 𝑡𝑡 Delta option prices.

ø¿¡¬√ƒ ≈¬ ∆«b≈»¬ … ≈Àƒ Œœ
Expected Option Payoffs • Δ= = Historical volatility: start with historical stock
ø¿¡¬√ƒ ≈¬ Ãb»ÀÕ … ≈Àƒ Œ–
𝐸𝐸 Call Payoff = 𝑆𝑆C 𝑒𝑒 èTY "TC 𝑁𝑁 𝑑𝑑? − 𝐾𝐾𝐾𝐾 𝑑𝑑> • Δà = 𝑒𝑒 TY("TC) 𝑁𝑁 𝑑𝑑? prices and calculate the standard deviation of the
𝐸𝐸 Put Payoff = 𝐾𝐾𝐾𝐾 −𝑑𝑑> − 𝑆𝑆C 𝑒𝑒 èTY "TC 𝑁𝑁 −𝑑𝑑? ΔD = −𝑒𝑒 TY("TC) 𝑁𝑁 −𝑑𝑑? logged changes in price over short periods of time.
• 0 ≤ Δà ≤ 1 − 1 ≤ ΔD ≤ 0

• Δà − ΔD = 𝑒𝑒 TY"
• Delta increases as the stock price increases.
• Δ—b»ÀÕ = 1, all other Greeks of stock = 0.

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 DELTA HEDGING
DELTA HEDGING Barrier Option Forward Start Option

Three types: For a call option expiring at time 𝑇𝑇 whose strike is
Overnight Profit
• Knock-in set on future date 𝑡𝑡 to be 𝑋𝑋𝑆𝑆C :
3 components in overnight profit:
Goes into existence if barrier is reached. 𝐶𝐶 𝑆𝑆C , 𝑋𝑋𝑆𝑆C , 𝑇𝑇 − 𝑡𝑡
• Gain on stocks
• Knock-out = 𝑆𝑆C 𝑒𝑒 TY "TC 𝑁𝑁 𝑑𝑑? − 𝑋𝑋𝑆𝑆C 𝑒𝑒 TB "TC 𝑁𝑁 𝑑𝑑>
• Gain on options
Goes out of existence if barrier is reached. = 𝑆𝑆C 𝑒𝑒 TY "TC 𝑁𝑁 𝑑𝑑? − 𝑋𝑋𝑒𝑒 TB "TC 𝑁𝑁 𝑑𝑑>
• Interest on borrowed/lent money
• Rebate 𝑆𝑆
ln C + 𝑟𝑟 − 𝛿𝛿 + 0.5𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡
The market-maker profit in a delta-hedged Pays fixed amount if barrier is reached. 𝑋𝑋𝑆𝑆C
𝑑𝑑? =
portfolio from time 𝑡𝑡 to 𝑡𝑡 + ℎ: Down vs. Up: 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
• If 𝑆𝑆% < 𝐵𝐵: 1
= ΔC 𝑆𝑆Cë` − 𝑆𝑆C − 𝑉𝑉Cë` − 𝑉𝑉C ln + (𝑟𝑟 − 𝛿𝛿 + 0.5𝜎𝜎 > )(𝑇𝑇 − 𝑡𝑡)
Up-and-in, up-and-out, up rebate = 𝑋𝑋
− 𝑒𝑒 B` − 1 ΔC 𝑆𝑆C − 𝑉𝑉C • If 𝑆𝑆% > 𝐵𝐵: 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
1 > Down-and-in, down-and-out, down rebate 𝑑𝑑> = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
≈ − 𝜖𝜖 ΓC − ℎ𝜃𝜃C − 𝑟𝑟ℎ ΔC 𝑆𝑆C − 𝑉𝑉C
2 Knock-in + Knock-out = Ordinary Option The time-0 value of the forward start option is:
where 𝜖𝜖 = 𝑆𝑆Cë` − 𝑆𝑆C Barrier option ≤ Ordinary Option 𝑉𝑉% = 𝐹𝐹%,CD
𝑆𝑆 × 𝑒𝑒 TY "TC 𝑁𝑁 𝑑𝑑? − 𝑋𝑋𝑒𝑒 TB "TC 𝑁𝑁 𝑑𝑑>

Special relationships:
Breakeven Chooser Option
• If barrier ≤ strike:
The price movement with no gain or loss to delta- For an option that allows the owner to choose at
up-and-in call = ordinary call
hedger is: time 𝑡𝑡 whether the option will become a European
• If barrier ≥ strike:
±𝑆𝑆𝑆𝑆 ℎ call or put with strike 𝐾𝐾 expiring at time 𝑇𝑇:
down-and-in put = ordinary put
𝑉𝑉C = max 𝐶𝐶 𝑆𝑆C , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 , 𝑃𝑃 𝑆𝑆C , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡
Delta-Gamma-Theta Approximation

1 Gap Option = 𝑒𝑒 TY "TC

max 0, 𝐾𝐾𝑒𝑒 T BTY "TC
− 𝑆𝑆C
𝑉𝑉Cë` = 𝑉𝑉C + ΔC 𝜖𝜖 + ΓC 𝜖𝜖 > + 𝜃𝜃C ℎ 𝐾𝐾? : Strike Price
2 + 𝐶𝐶 𝑆𝑆C , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡
𝐾𝐾> : Trigger Price
Black-Scholes Equation 𝐾𝐾? determines the amount of the payoff. 𝑉𝑉% = 𝑒𝑒 TY "TC
⋅ 𝑃𝑃 𝑆𝑆% , 𝐾𝐾𝑒𝑒 T BTY "TC
, 𝑡𝑡 + 𝐶𝐶 𝑆𝑆% , 𝐾𝐾, 𝑇𝑇
1 > > 𝐾𝐾> determines whether the option will have a

𝜎𝜎 𝑆𝑆 Γ + 𝑟𝑟 − 𝛿𝛿 𝑆𝑆Δ + 𝜃𝜃 = 𝑟𝑟𝑟𝑟 Lookback Option

2 payoff.

0, 𝑆𝑆" ≤ 𝐾𝐾> An option for which the strike price is not fixed:
Boyle-Emanuel Formula Payoffˇ¡« ø¡‘‘ = • Lookback call: strike price is the lowest stock
𝑆𝑆" − 𝐾𝐾? , 𝑆𝑆" > 𝐾𝐾>
Boyle-Emanuel annual variance of return when 𝐾𝐾? − 𝑆𝑆" , 𝑆𝑆" ≤ 𝐾𝐾>
Payoffˇ¡« …¸b = price through the option period.
rehedging every ℎ in period 𝑖𝑖: 0, 𝑆𝑆" > 𝐾𝐾>
1 TY" TB" Payoff$»»Õ%¡ÀÕ ø¡‘‘ = 𝑆𝑆" − 𝑆𝑆"
𝑉𝑉𝑉𝑉𝑉𝑉 𝑅𝑅`,ñ = 𝑆𝑆 > 𝜎𝜎 > Γ > ℎ GapCall = 𝑆𝑆% 𝑒𝑒 𝑁𝑁 𝑑𝑑? − 𝐾𝐾? 𝑒𝑒 𝑁𝑁 𝑑𝑑>
2 GapPut = 𝐾𝐾? 𝑒𝑒 TB" 𝑁𝑁 −𝑑𝑑> − 𝑆𝑆% 𝑒𝑒 TY" 𝑁𝑁 −𝑑𝑑? • Lookback put: strike price is the highest stock
where 𝑑𝑑? and 𝑑𝑑> are based on 𝐾𝐾> price through the option period.
GapCall − GapPut = 𝑆𝑆% 𝑒𝑒 TY" − 𝐾𝐾? 𝑒𝑒 TB" Payoff$»»Õ%¡ÀÕ …¸b = 𝑆𝑆" − 𝑆𝑆"

EXOTIC OPTIONS
EXOTIC OPTIONS Exchange Option where

𝐶𝐶(𝐴𝐴, 𝐵𝐵) = 𝐹𝐹 D 𝐴𝐴 ⋅ 𝑁𝑁 𝑑𝑑? − 𝐹𝐹 D 𝐵𝐵 ⋅ 𝑁𝑁 𝑑𝑑> 𝑆𝑆C : max price of stock over the period 0 to 𝑡𝑡
Asian Option
𝐴𝐴 𝑆𝑆 arithmetic average 𝑃𝑃(𝐴𝐴, 𝐵𝐵) = 𝐹𝐹 D 𝐵𝐵 ⋅ 𝑁𝑁 −𝑑𝑑> − 𝐹𝐹 D 𝐴𝐴 ⋅ 𝑁𝑁 −𝑑𝑑? 𝑆𝑆C : min price of stock over the period 0 to 𝑡𝑡
𝑆𝑆 = 𝐹𝐹 D 𝐴𝐴 1
𝐺𝐺 𝑆𝑆 geometric average ln D + 𝜎𝜎 > 𝑇𝑇 − 𝑡𝑡
? 𝐹𝐹 𝐵𝐵 2
ÿ ÿ
𝑑𝑑? =
ÿ
Cı? 𝑆𝑆C
𝜎𝜎 𝑇𝑇 − 𝑡𝑡
𝐴𝐴 𝑆𝑆 = 𝐺𝐺 𝑆𝑆 = 𝑆𝑆C MONTE CARLO VALUATION
MONTE CARLO VALUATION
𝑁𝑁 𝑑𝑑> = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇 − 𝑡𝑡
Cı?
𝐺𝐺 𝑆𝑆 ≤ 𝐴𝐴 𝑆𝑆 Simulating Standard Normal Variables
𝜎𝜎 = 𝜎𝜎> + 𝜎𝜎!> − 2𝜌𝜌𝜎𝜎 𝜎𝜎! ?>
Average Price Average Strike
𝑧𝑧 = 𝑢𝑢ñ − 6 𝑧𝑧ñ = 𝑁𝑁 T? 𝑢𝑢ñ
Payoffø¡‘‘ max 0, 𝑆𝑆 − 𝐾𝐾 max 0, 𝑆𝑆 − 𝑆𝑆 All-or-nothing Option ñı?

Payoff…¸b max 0, 𝐾𝐾 − 𝑆𝑆 max 0, 𝑆𝑆 − 𝑆𝑆
Option Payoff Time-t Price Simulating Lognormal Stock Prices
The value of an Asian option is less than or 0, 𝑆𝑆" ≤ 𝐾𝐾
Asset • If not interested in the intermediate prices:
equal to the value of an otherwise equivalent 𝑆𝑆C 𝑒𝑒 TY "TC
𝑁𝑁 𝑑𝑑?
Call 𝑆𝑆" , 𝑆𝑆" > 𝐾𝐾 ã
𝑆𝑆" = 𝑆𝑆C 𝑒𝑒 èTYT%.ìí "TC ëí "TC⋅¥
ordinary option.
Asset 𝑆𝑆" , 𝑆𝑆" < 𝐾𝐾 • If interested in the intermediate prices:
As 𝑁𝑁 increases: 𝑆𝑆C 𝑒𝑒 TY "TC
𝑁𝑁 −𝑑𝑑?
Put 0, 𝑆𝑆" ≥ 𝐾𝐾 ã
𝑆𝑆Cë` = 𝑆𝑆C 𝑒𝑒 èTYT%.ìí `ëí `⋅¥ä
• Value of average price option decreases
• Value of average strike option increases Cash 0, 𝑆𝑆" ≤ 𝐾𝐾 𝑆𝑆Cë>` = 𝑆𝑆Cë` 𝑒𝑒 èTYT%.ìí ã `ëí `⋅¥ã

𝑒𝑒 TB "TC
𝑁𝑁 𝑑𝑑>
Call $1, 𝑆𝑆" > 𝐾𝐾 .
Compound Option Cash $1, 𝑆𝑆" < 𝐾𝐾 .
The value of the underlying option at time 𝑡𝑡? 𝑒𝑒 TB "TC
𝑁𝑁 −𝑑𝑑>
Put 0, 𝑆𝑆" ≥ 𝐾𝐾 ã
𝑆𝑆"T` = 𝑆𝑆"T>` 𝑒𝑒 èTYT%.ìí `ëí `⋅¥'⁄ä
= 𝑉𝑉 𝑆𝑆Cä , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡?
èTYT%.ìí ã `ëí `⋅¥'
Maxima and Minima 𝑆𝑆" = 𝑆𝑆"T` 𝑒𝑒
The value of the compound call at time 𝑡𝑡?
• max 𝐴𝐴, 𝐵𝐵 = max 0, 𝐵𝐵 − 𝐴𝐴 + 𝐴𝐴

= max 0, 𝑉𝑉 𝑆𝑆Cä , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡? − 𝑥𝑥

max 𝐴𝐴, 𝐵𝐵 = max 𝐴𝐴 − 𝐵𝐵, 0 + 𝐵𝐵
The value of the compound put at time 𝑡𝑡? Risk-neutral vs. True
• max 𝑐𝑐𝐴𝐴, 𝑐𝑐𝐵𝐵 = 𝑐𝑐 ⋅ max 𝐴𝐴, 𝐵𝐵 𝑐𝑐 > 0
= max 0, 𝑥𝑥 − 𝑉𝑉 𝑆𝑆Cä , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡? • Use the risk-neutral distribution only when
max 𝑐𝑐𝐴𝐴, 𝑐𝑐𝐵𝐵 = 𝑐𝑐 ⋅ min 𝐴𝐴, 𝐵𝐵 𝑐𝑐 < 0
where discounting is needed.
• max 𝐴𝐴, 𝐵𝐵 + min 𝐴𝐴, 𝐵𝐵 = 𝐴𝐴 + 𝐵𝐵
• 𝐾𝐾 is the strike of the underlying option • Use the true distribution when discounting is
⇒ min 𝐴𝐴, 𝐵𝐵 = − max 𝐴𝐴, 𝐵𝐵 + 𝐴𝐴 + 𝐵𝐵 not needed.
• 𝑥𝑥 is the strike of the compound option

• 𝑇𝑇 is the maturity of the underlying option Standard Deviation of Monte Carlo Estimate
• 𝑡𝑡? is the maturity of the compound option 𝜎𝜎œ
𝜎𝜎œ =
𝑛𝑛
Put-call parity for compound option: where
• CallonCall − PutonCall = 𝐶𝐶ÇÉB − 𝑥𝑥𝑒𝑒 TBCä 𝜎𝜎œ : std. dev. of individual option price
• CallonPut − PutonPut = 𝑃𝑃ÇÉB − 𝑥𝑥𝑒𝑒 TBCä 𝜎𝜎œ : std. dev. of Monte Carlo estimate for the option

price
𝑛𝑛: number of stock price paths

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Control Variate Method Put-Call Parity
𝑌𝑌 ∗ = 𝑌𝑌 + 𝛽𝛽 𝑋𝑋 − 𝑋𝑋 𝐶𝐶 − 𝑃𝑃 = 𝑃𝑃 0, 𝑇𝑇 𝐹𝐹 − 𝐾𝐾

where
Caplet and Floorlet
𝑌𝑌 ∗ = Control variate estimate for Option 𝑌𝑌
A caplet is a call option on interest rate.
𝑌𝑌 = Monte Carlo estimate for Option 𝑌𝑌
At time 𝑇𝑇, the value of 𝑇𝑇 + 1 -year caplet is:
𝑋𝑋 = Exact/True price of Option 𝑋𝑋
max 0, 𝑅𝑅" − 𝐾𝐾,
𝑋𝑋 = Monte Carlo estimate for Option 𝑋𝑋 × Notional
1 + 𝑅𝑅"
𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 ∗ = 𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 + 𝛽𝛽 > 𝑉𝑉𝑉𝑉𝑉𝑉 𝑋𝑋 − 2𝛽𝛽𝐶𝐶𝐶𝐶𝐶𝐶 𝑌𝑌, 𝑋𝑋 A floorlet is a put option on interest rate.

At time 𝑇𝑇, the value of 𝑇𝑇 + 1 -year floorlet is:
𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 ∗ is minimized when:
ï max 0, 𝐾𝐾, −𝑅𝑅"
𝐶𝐶𝐶𝐶𝐶𝐶 𝑌𝑌, 𝑋𝑋 ñı? 𝑌𝑌ñ − 𝑌𝑌 𝑋𝑋ñ − 𝑋𝑋 × Notional
𝛽𝛽 = = ï 1 + 𝑅𝑅"
𝑉𝑉𝑉𝑉𝑉𝑉 𝑋𝑋 ñı? 𝑋𝑋ñ − 𝑋𝑋
>
A cap (floor) is a collection of caplets (floorlets).
When 𝛽𝛽 is set to minimize 𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 ∗ :
𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 ∗ = 𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 1 − 𝜌𝜌´,* > Using Black Formula, caplets and floorlets can be
priced as:
where 1
𝐶𝐶𝐶𝐶𝐶𝐶 𝑋𝑋, 𝑌𝑌 Caplet = 1 + 𝐾𝐾, ⋅ Put strike =
𝜌𝜌´,* = 1 + 𝐾𝐾,
𝑉𝑉𝑉𝑉𝑉𝑉 𝑋𝑋 ⋅ 𝑉𝑉𝑉𝑉𝑉𝑉 𝑌𝑌 1
Floorlet = 1 + 𝐾𝐾, ⋅ Call strike =
1 + 𝐾𝐾,
Antithetic Variate Method

For every 𝑢𝑢ñ , also simulate using 1 − 𝑢𝑢ñ . Binomial Interest Rate Trees
For every 𝑧𝑧ñ , also simulate using – 𝑧𝑧ñ . 1. The trees do not necessarily recombine.
2. Interest rates are continuously compounded,
Stratified Sampling unless otherwise specified.
Break the sampling space into equal size spaces. 3. Risk-neutral probabilities are given, not
Then, scale the uniform numbers into the equal calculated.

size spaces. Black-Derman-Toy Model

1. Use effective interest rates

2. 𝑝𝑝∗ = 0.5
INTEREST RATE MODELS
INTEREST RATE MODELS 3. The ratio between two consecutive nodes is

Zero-coupon Bond 𝑒𝑒 >ífi `

The price at time 𝑇𝑇 of a zero-coupon bond 𝜎𝜎C : short-term volatility
maturing at time 𝑇𝑇 + 𝑠𝑠 for $1 is:
𝑃𝑃 𝑇𝑇, 𝑇𝑇 + 𝑠𝑠 The yield volatility in 1 period for a bond maturing
at time 𝑇𝑇 is:
Forward Price 1 𝑦𝑦 ℎ, 𝑇𝑇, 𝑟𝑟É
The forward price at time 𝑡𝑡 of a bond maturing at Yield volatility " = ⋅ ln
2 ℎ 𝑦𝑦 ℎ, 𝑇𝑇, 𝑟𝑟p
time 𝑇𝑇 + 𝑠𝑠 and delivered at time 𝑇𝑇 is:

𝐹𝐹C,","ëÚ = 𝐹𝐹C," 𝑃𝑃 𝑇𝑇, 𝑇𝑇 + 𝑠𝑠

𝑃𝑃 𝑡𝑡, 𝑇𝑇 + 𝑠𝑠
=
𝑃𝑃 𝑡𝑡, 𝑇𝑇

Black Model
Consider an option on a bond at time 0 which
allows buying/selling a bond at time T that
matures at time 𝑇𝑇 + 𝑠𝑠.

𝐶𝐶 = 𝑃𝑃 0, 𝑇𝑇 𝐹𝐹 ⋅ 𝑁𝑁 𝑑𝑑? − 𝐾𝐾 ⋅ 𝑁𝑁 𝑑𝑑>
𝑃𝑃 = 𝑃𝑃 0, 𝑇𝑇 𝐾𝐾 ⋅ 𝑁𝑁 −𝑑𝑑> − 𝐹𝐹 ⋅ 𝑁𝑁 −𝑑𝑑?
𝐹𝐹
ln + 0.5𝜎𝜎 > 𝑇𝑇
𝑑𝑑? = 𝐾𝐾
𝜎𝜎 𝑇𝑇
𝑑𝑑> = 𝑑𝑑? − 𝜎𝜎 𝑇𝑇
𝑃𝑃(0, 𝑇𝑇 + 𝑠𝑠)
𝐹𝐹 = 𝐹𝐹%,","ëÚ =
𝑃𝑃(0, 𝑇𝑇)
𝜎𝜎 = volatility of bond forward price
𝑉𝑉𝑉𝑉𝑉𝑉 ln 𝐹𝐹C,","ëÚ
= , 0 < 𝑡𝑡 ≤ 𝑇𝑇
𝑡𝑡

𝑃𝑃(𝑡𝑡, 𝑇𝑇 + 𝑠𝑠)
𝑉𝑉𝑉𝑉𝑉𝑉 ln
𝑃𝑃(𝑡𝑡, 𝑇𝑇)
= , 0 < 𝑡𝑡 ≤ 𝑇𝑇
𝑡𝑡

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