Valuation of Equity Derivatives

Valuation
of Equity Derivatives
Dr Mark Beinker

STRONGnet school
Bielefeld, 21./22. June 2011

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 Valuation of Equity Derivatives

Whats a derivative?

More complex financial products are derived

derived from simpler products

Whats not a derivative?

Stocks, interest rates, FX rates, oil prices,

Derivatives are pay off claims somehow based on prices of simpler

products or other derivatives
Derivatives may be traded via an exchange or directly between two
counterparties
p ((OTC: over-the-counter))
OTC-Derivatives are based on freely defined agreements between
counterparties and may be arbitrarily complex

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 Valuation of Equity Derivatives

Example I: Equity Forward

Buying (or selling) stocks at some future date

Long position: you bought the stock

off
(Your counterparty is short)
Pay o

Pay off ST K at
maturity (expiry) T

Physical Settlment: ST
K
get Stock, pay K
Stock Price ST at
Cash Settlment: maturity p y) T
y ((expiry)
get ST K Forward Price K
or Strike Price
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 Valuation of Equity Derivatives

Example II: Plain Vanilla Option

Most simple and liquidly traded options

(Plain Vanilla) Call Option (Plain Vanilla) Put Option

Pay off

Pay off
ST ST
K K

Pay off: Pay off:

maxST K ,0 ST K maxK ST ,0 K ST

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 Valuation of Equity Derivatives

Example III: Bonus Certificate

Getting more than you might expect

Pay off
Zero strike call
Full protection
against minor losses
Pay off

H K ST

= +

ay off
Everywhere at or above stock
price but still could be sold at
price,

Pa
current stock price level or below Down and out put

H K ST

If Protection level H is hit Put becomes worthless, if

once before expiry, barrier level H is hit once
H K ST
protection gets lost. before expiry.
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 Valuation of Equity Derivatives

Even more complex structures

There are no limits to complexity

Baskets as underlying
Simple basket products: Pay off depends on total value of basket of stocks
Correlation basket products: Pay off depends on performance of single stocks
within the baskets, e.g. the stock that performs worst or best, etc.
Si l ti off ttrading
Simulation di strategies
t t i

Quantos
Pay off in a currency different from the stock currency

Combination with other risk factors (hybrid derivatives)

E.g. Convertible Bonds (bonds that could be converted into stocks)

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 Valuation of Equity Derivatives

Stocks

Know your underlying

A Stock or Share is the certification of the ownership of a part of a

company, the
h community i off shareholders
h h ld iis the
h owner off the
h whole
h l
company
Issued stock is equivalent to tier 1 equity capital of the corporation
The stock may pay a dividend
Th company can be
The b lilisted
t d att one or more stock
t k exchanges
h

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 Valuation of Equity Derivatives

Stock process

The Geometric Brownian motion of stocks

Standard normal distributed

Drift Volatility random number

dS Sdt SdW dW dt
2
d ln S dt dW
2

Divends are neglected!

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 Valuation of Equity Derivatives

Time value of money

Time is money.
money But how much money is it?

Money today is worth more than the same amount in some distant
future
Risk of default
Missing earned (risk free) interest

Interest earned over

Discounting time period T: XrT
Cashflow Y at
future time T is
worth now Y/(1+rT) =X
+ =Y

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 Valuation of Equity Derivatives

A note on notation I

Compounding of interest rates

Usually, interest is paid on a regular basis, e.g. monthly, quarterly or

annually
ll
If re-invested, the compounding effect is significant
Number
of years

r r r r nm
1 1 1 1
Compoundings
m m m m
per year nm times
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 Valuation of Equity Derivatives

A note on notation II

The Continuous compounding limit

Continuous compounding is the limit of compounding in infinitesimal short time periods

nm
r
lim 1 e rT , T n
n const.
m m

rT Value of one unit at future time T as of today t=0.

e Also: discount factor or zero bond
r: continuous
ti compoundingdi ratet

This mathematically convenient notation is used throughout the rest of the

talk. It is also most often assumed in papers on finance.
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 Valuation of Equity Derivatives

Example I: valuation of the Forward contract

First Try: Forward value based on expectation

1. Step: Calculate expectation of forward pay off

EST K EST K e T S 0 K
2. Step: Discount expected pay off to today

VForward
E
e r T S 0 e rT K
T
Fair price for new contract: K e S0
To avoid losses, bank would have either
1. sell as many Forwards with same strike and maturity as they buy
2. or have to rely on the correctness of the above formula on average
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 Valuation of Equity Derivatives

Arbitrage

Making money out of nothing

Arbitrage is the art of earning money (immediately) without taking

risk
i k
Example: Buy stock at 10 and sell at 15
Because of bid/ask
bid/ask-spreads,
spreads broker buys at 10 and sells at 10
10.05
05
0.05 in this example is the broker fee

Since moneyy earned byy arbitrage

g is easyy money,
y, market participants
p p
will take immediate advantage of arbitrage opportunities
If the markets are efficient, there are no opportunities for arbitrage
If you can replicate a pay off with a strategy built on liquidly traded instruments,
this must be the fair value of the pay off > there is no free lunch!
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 Valuation of Equity Derivatives

Example I: valuation of the Forward contract I

Replicating the Forward agreement

Assumption: S 0 e rT K
1. Step: Borrow at interest rate r for term T the money amount B e rT K
2. Step: Buy the stock and put the rest of the money aside: A e rT K S 0
3 Step: At time T,
3. T loan has compounded to K: e rT B K
4. Step: Exchange stock with strike K and pay back loan

Amount A has been earned arbitrage free!

To avoid arbitrage, the fair strike must be K e rT S 0

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 Valuation of Equity Derivatives

Example I: valuation of the Forward contract II

Lessons learned
rT
VForward S 0 e K
The real world expectation of S at future time t doesnt matter at all!
Hedged counterparties face no market risk
C dit risk
Credit i k remains
i

Value of the Forward is equal to the financing cost

No fee for bearing market risk

Required assumptions:
No arbitrage
Possible to get loan at risk-free interest rate

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 Valuation of Equity Derivatives

Adding optionality

For options,
options the distribution function matters

Plain Vanilla option: cut off distribution

y off
Pay
f
function ik K
i at strike
European Call option pay off:

maxST K ,0 ST K
ST
K

Q: Is there any arbitrage free replication

strategy to finance these pay offs?
K ST

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 Valuation of Equity Derivatives

Itos lemma

The stochastic process of a function of a stochastic process

Process of underlying: dS Sdt SdW

Fair value V of option is function of S: V V (S )
Itos lemma:
V V 1 2V 2 2 V
dV S S dt SdW
S t 2 S S
2

Caused by stochastic
term ~ dt

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 Valuation of Equity Derivatives

Replication portfolio for general claims

Replicate option pay off by holding portfolio of cash account and stock

Ansatz: V B xS with dB rBdt

Changes in option fair value V
V V 1 2V 2 2 V
dV S S
dt SdW rBdt xSdt xSdW
S t 2 S S
2

V
Choose x and insert for B V xS
S

V 1 2V 2 2 V With this choice of

S rB rV rS x, the stochastic
t 2 S 2
S term vanishes

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 Valuation of Equity Derivatives

A closer look at the Black-Scholes PDE

The arbitrage free PDE of general claims

V V 1 2 2 2V
rV rS S
t S 2 S 2

Final equation does Replication portfolio

not depend on is self-financing

Additional terms for deterministic dividends have been neglected

With time dependent r=r(t) or =(t), the PDE is still valid

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 Valuation of Equity Derivatives

Solving the Black-Scholes PDE

Numerical methods for pricing derivatives

Trees

Analytic Solutions
K rT N (d 2 )
VC SN (d1 ) Ke

Semi-Analytic Solutions
CMS
V floor ( 0)
D(t p )
L0
1 f (K )P(K )

K
P( x) f ( x)dx
Which
Whi h
Method ? Finite
Difference

Finite
Monte Elements
C l
Carlo

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 Valuation of Equity Derivatives

The famous formula of Black and Scholes

Analytic Solution of Black-Scholes

Black Scholes PDE for Call options

Solve the Black-Scholes PDE for Plain Vanilla Call options

V V 1 2 2 2V
V
rV rSS S
t S 2 S 2
V (T , S ) S (T ) K

Specific products can be defined as

set of end and boundary conditions V (t ,0) 0
of the Black-Scholes PDE lim V (t , S ) S K
S

Solution: the famous result of Black and Scholes

VCall SN (d1 ) Ke rT N (d 2 )
l (S / K ) rT
ln( T 1 2
d1, 2 T
T 2
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 Valuation of Equity Derivatives

Binomial tree single step

Simulating the stochastic process on a tree like grid

Probability for Su
up movement p

S Stock value after

up/down movement
Stock price at origin

1p
Sd



dt
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 Valuation of Equity Derivatives

Binomial tree parameters

Four parameters and two equations

Parameters:

Su,Sd : Value of stock after up/down move

p: Probability of up move

dt: Length of time step (determines the accuracy of the calculation)

Equations: Derived from lognormal

ES ( dt
d ) pS
stock price process
S u (1 p ) S d Se
S rdt
var S ( dt ) p (1 p )S u S d S e
2 2 2 rdt
e 2 dt

1

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 Valuation of Equity Derivatives

Binomial tree choices

Popular choices to determine parameters

Cox-Ross-Rubinstein choice: S u uS and S d S / u

u e dt

ue rdt 1
p 2
u 1
Jarrow-Rudd-choice: p 0 .5
r 1 2 dt dt
S u Se 2

r 1 2 dt dt
S d Se 2

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 Valuation of Equity Derivatives

Binomial trees application

A li d decision
Applied d i i trees
t
Vuu
Vu

Determined by
Calculate option price by V Vud option
p pay
p y off
backward induction Vd function

V ppVu (1 p )Vd
p pVuu (1 p )Vud Vdd
(1 p ) pV
Vud (1 p )Vdd
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 Valuation of Equity Derivatives

Trinomial trees

Two step binomial tree or explicit finite difference scheme

Two-step
Key features of trinomial trees

6 free parameters (three

different states, two
probabilities, one time step)
Otherwise, approach is similar
t binomial
to bi i l trees
t
More flexibility than binomial
tree
Faster convergence (two time
steps in one)
For certain geometries,
trinomial trees are identical to
explicit finite difference
method

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 Valuation of Equity Derivatives

Finite differences

Solving the PDE on a rectangular grid

Application of finite difference method

1 Ch
1. Choose one off the
th well
ll established
t bli h d finite
fi it difference
diff schemes
h
for PDEs of the parabolic type (diffusion equation), e.g. explicit
or implicit Euler scheme or Crank Nicholson scheme
2. Discretise PDE on a rectangular lattice according to finite
difference scheme
3. Apply pay off function as final boundary condition
4. Depending on option type, apply Dirichlet or (generalised) von
Neumann (e.g. second order derivative is zero) conditions on
upper and lower boundaries
5. Roll back throw lattice to get solution

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 Valuation of Equity Derivatives

Comparison of numerical methods

Instead of trees,
trees use finite difference method!
7.22

7.2 Binomial tree

7.18

7.16 Trinomial tree

price

7 14
7.14
Option p

7.12 Finite
7.1 differences

7.08
Analytical
7.06

7.04
20 30 40 50
Number of time steps
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 Valuation of Equity Derivatives

Monte Carlo simulation

The method of last means

If everything else false, use Monte Carlo simualtion

Easy to implement, but bad performance

Typical applications:
Underlying is basket of underlying (e
(e.g.
g many dimension)
Multi-factor problems
Path dependent problems

Implementation methods
Simulate stochastic differential using small time steps
Better: Integrate
g of longer
g time p period and draw random numbers directlyy from
log-normal distribution function
Calculate pay off based on simulated stock prices and discount to today
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 Valuation of Equity Derivatives
Assumptions
Which of these assumptions hold in reality?
There are no transaction costs
Continuous trading is possible
Markets have infinite liquidity
Di id d are deterministic
Dividends d t i i ti
Markets are arbitrage free
Volatility has only termstructure
Stocks follow log-normal Brownian
motion
There is no counterparty risk
Everybody can finance at risk-free rate
No, there are bid-ask Spreads
No, due to technical limitations
No, problem for small caps
N company performance
No, f dependent
d d t
Almost, because of transaction costs
No volatility depends on strike and term
No,
No, only approximately, problems of fat
tails
No, as the last crisis has shown
No, financing depends varies broadly
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 Valuation of Equity Derivatives

Volatility smile

Volitility depends on strike (moneyness)

( moneyness) and expiry

Smile vanishes for long expiries

Volattility

At-the-money:
Spot equals Strike

Using Black-Scholes: putting the wrong number (i.e. volatility) into the
wrong formula to get the right price.
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 Valuation of Equity Derivatives

Local volatility surface

Transform (K,T)
(K T) into (S,T)
(S T)
When S moves, local volatility
moves in wrong direction
Volattility

Structure is much
more complex

Local Volatility: Allows for fit to the whole volatility surface, but behaves
badly. Still, it is widely used.
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 Valuation of Equity Derivatives

Examples of other methods of modelling volatility I

More advanced volatility models

Displaced diffusion
Assume S+d instead of S to follow the lognormal process

d ( S d ) r ( S d )dt ( S d )dW
Jumps
Add additional stochastic Poisson process to spot process
dS (r ) Sdt SdW SdJ Poisson process

Rate of poisson process Relative jjump

p size
or jump intensity

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 Valuation of Equity Derivatives

Other methods of modelling volatility II

More advanced volatility models

Stochastic Volatility
Model volatilityy as second stochastic factors,, e.g.
g Heston model
Instantaneous
variance Wiener processes
with correlation

dS rSdt SdWS
d ( )dt dW
Mean reversion
Long term average
rate Volatility of
variance
volatility

Local-Stoch-Vol
Combination of local volatility and stochastic volatility 34
 Valuation of Equity Derivatives

Dividends I

Dividend payments: interest equivalent for equities

Dividends compensate the shareholder for providing money (equity)

Some companies dont pay dividends, most pay annually, some
even more often
In general, dividend is paid a few days after the (annual) shareholder
meeting
Di id d paymentt amountt iis lloosely
Dividend l related
l t d tto th
the companys
P&L
Regardless of the above, most models assume deterministic
dividends
i.e. Dividend amount or rate and payment date are known and fixed
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 Valuation of Equity Derivatives

Dividends II

Three methods of modeling dividends

Continuous dividend yield q: continuous payment of dividend

payment proportional
i l to current stock i S
k price
Unrealistic, but mathematically easy to handle

Discrete proportional dividends: dividend is paid at dividend payment

date, amount of dividend is proportional to stock price S
Tries to model dividends loose dependency on P&L (assuming P&L and stock
price to be strongly correlated)

Discrete fixed dividends: fixed dividend amount is paid at dividend

payment date
Causes headaches for the quant (i.e. the person in charge of modelling the fair
value of the derivative)
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 Valuation of Equity Derivatives

Dividends III

Impact of dividends on stock process I

Continuous dividend yield:

dS q Sdt SdW
Discrete dividends
1. Method: Subtract dividend value from S and model S without dividends
proportional dividends
n

S S 1 Di
*

fixed dividends i 1

n
S S e rti Di
*

i 1
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 Valuation of Equity Derivatives

Dividends III

Impact of dividends on stock process II

Discrete dividends
2. Method: Modelling (deterministic) jumps in the stochastic process with jump
conditions defined as
Proportional dividend

S ti S ti 1 Di
Fixed dividend

S ti S ti Di

Methods 1 and 2 assume different stochastic processes,

i.e. the volatilities are different!
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 Valuation of Equity Derivatives

Example Ia: Forward contract with dividends

Replicating the Forward agreement

1. Step: Borrow the money to buy the stock at price S0

2 Step: Split loan into two parts
2.
a) For time period tD at rate rD the amount
e rDt D D
b) For time period T at rate r the rest
S 0 e rDt D D
3. Step: At dividend payment date tD, receive dividend D and
pay back first loan which is now worth D

4. Step: At expiry, the second loan amounts to

e rT S 0 e rDt D D
In order to make the Forward contract be arbitrage free, the fair strike must

be K e rT S 0 e rD t D D
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 Valuation of Equity Derivatives

Example Ia: Forward Contract with dividends

Formulas for Forward agreements with dividends

Continuous dividend yield

Fair strike:
K e r q T S 0
Fair value:
VForward e qTT S 0 e rTT K
Proportional discrete dividends
Fair strike: n

K e 1 Di
rT

i 1
Fair value:
n
rTT
VForward S 0 1 Di e K
i 1
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 Valuation of Equity Derivatives

Example Ia: Forward Contract with dividends

Formulas for Forward agreements with dividends

Fixed discrete dividends

Fair strike:
n

K e S 0 e Di
rT rti

i 1
Fair value:
n
VForward S 0 e rti Di e rT K
i 1

Dividends reduce the forward value by reducing the financing cost of the
replication strategy!
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 Valuation of Equity Derivatives

Impact of dividends on derivative prices

Currently no well
Currently, well-established
established model for stochastic dividends

Dividends can be hedged,

b not ((easily)
but il ) modelled
d ll d

Pay off
stochastically
Impact on option price is
significant
Trick: use dividends to hide
option costs

H K ST

Everywhere at or above stock

since between today and T lies a stream of
price, but still could be sold at
dividend payments!
current stock price level

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 Valuation of Equity Derivatives

Hedging derivative in practice

Hedging makes the difference

Hedging: trading the replication portfolio

Reduce transaction cost by
Frequent, but discrete hedging
Hedging derivative portfolio as a whole

Improve Hedging performance

Hedging
g g based on Greeks

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 Valuation of Equity Derivatives

Greeks

Partial derivatives named by Greek letters

V
Delta V
S Most important Vega
Greeks
2V
2 Gamma 2V
S Volga
2
V
Theta
t
Bucketed
2V
Sensitivities Vanna
S
V
Rho
r
Type of hedging strategy often named after Greeks hedged, e.g. Delta-Hedging
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 Valuation of Equity Derivatives

Example IIIb: down-and-out Put

Present Value of Down

Down-and-out
and out Put option
Pay off

Fair value Down-and-out Put

increases

H K ST

Fair value
falls to zero
Put Option
p

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 Valuation of Equity Derivatives

Example IIIb: down-and-out Put

Delta of Down
Down-and-out
and out Put option
Delta Down-and-out Put

Delta Put Option

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 Valuation of Equity Derivatives

Example IIIb: down-and-out Put

Gamma of Down
Down-and-out
and out Put option

Gamma Down-and-out Put

Gamma Put Option

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 Valuation of Equity Derivatives

Example IIIb: down-and-out Put

Vega of Down-and-out
Down and out Put option

Vega Down-and-out Put

Vega Put Option

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 Valuation of Equity Derivatives

Counterparty default risk

Calculation of the Credit Value Adjustment (CVA)

Hazard rate: Probability of Positve part of

default in time intervall dt derivative pay off

T
V V 1 R he e E V (t ) dt
D ht rt

0
Defaultable Recovery Survival probability
Fair Value Rate until time t

Counterparty risk can be traded by means of Credit Default Swaps paying

periodically a premium for insurance against default of specific counterparty
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 Valuation of Equity Derivatives

Forward fair value with CVA

Counterparty risk adds option feature

Forward with CVA:

D
VForward
S e rTT K (1 R) 1 e hT VCall
S e rT K (1 R)1 e SN (d ) Ke
hT
1
rT
N (d 2 )
Call option with CVA:

D
VCall
VCall (1 R)VCall 1 e hT
Special case R=0:

D
VCall
e hT SN (d1 ) Ke rT N (d 2 )
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 Valuation of Equity Derivatives

CVA for the banks derivatives portfolio

Effect of Netting Agreements and Collateral Management

Before Netting After Netting
Trrades

Trrades
Netting of
Exposures

Relevant for CVA

Netting Sets

Collateral
Short Long
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 Valuation of Equity Derivatives

Summary

What you might have learnt

Whats a derivative
Typical equity derivatives and how they work
g
General idea behind the method of arbitrage-free pricing
p g
The assumptions of the theory and their validity in reality
Whatss missing in the theoretical framework
What
Impact of counterparty default risk

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 Valuation of Equity Derivatives

Literature

Financial Calculus : An Introduction to Derivative Pricing, Martin

B
Baxter & Andrew
A d R
Rennie,
i Cambridge
C b id U University
i i PPress, 1996
Options, Futures & Other Derivatives, John C. Hull, 7th edition,
Prentice Hall India
India, 2008
Derivatives and Internal Models, Hans-Peter Deutsch, 4th edition,
Palgrave
g McMillan,, 2009
Derivate und interne Modelle: Modernes Risikomanagement,
Hans-Peter Deutsch, 4. Auflage, Schffer-Poeschel, 2008

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 Valuation of Equity Derivatives

Your Contact

d-fine

Dr. Mark W. Beinker Frankfurt

Partner Mnchen
+49 69 90737-305 London
Hong Kong
e-Mail: mark.beinker@d-fine.de Zrich

Zentrale

d-fine GmbH
O
Opernplatz
l t 2
60313 Frankfurt am Main
Deutschland

T. +49 69-90737-0
T
F: +49 69-90737-200
www.d-fine.de
2010 d-fine All rights reserved 54
 Valuation of Equity Derivatives

Glossar

Frequently used expressions

S Underlying asset/stock price Stock price process dS Sdt SdW

r
dS rSdt SdW
(d f lt) risk
(default) i k free
f i t
interest
t rate
t Risk
Ri k neutral
t l stock
t k
price process
Volatility
Pay off function of
max ST K ,0 ST K

call/put
ll/ t option
ti
K Strike price
Discount factor r T t
T Expiry Date = value of zero bond e
Drift of underlying Black-Scholes V V 1 2 2 2V
rV rS S
equation t S 2 S 2
V(t) Value of derivative at time t Short position Position sold

dW Stochastic differential ~ dt Long position Position bought

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