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SOA Exam MFE Flash Cards

Spring 2007
Forwards
Put Call Parity
Spreads

A Bull Spread consists of either buying a call with strike price K 1 and selling
one with strike price K 2 > K 1 , or buying a put with strike price K 1 and selling a put
with strike price K 2 < K 1 .

A Bear Spread is the opposite of a bull spread; either for calls K 2 < K 1 or for
puts K 2 > K 1 .

Exchange Rate Terminology


x0 =Spot Exchange Rate

rd =Risk Free Rate for Domestic Currency

r f =Risk Free Rate for Foreign Currency

−r f T
x0 e = Pre-paid forward exchange rate

( rd −r f )T
x0 e = Forward exchange rate

Currency Options
Asset = Call – Put + PV(Strike Price)
−r f T
x0 e = Call – Put + Ke −rd T

A call to purchase a foreign with domestic is equivalent to a put to sell


domestic for foreign.

1 1  C ( x0 , K , T )
P , , T  =
 x0 K  Kx 0

Binomial Trees
Option Price = ∆ S + B =
e [ p*Cu + (1− p*) Cd]
−r h

−δT  Cu − C d  −δT  C u − C d   uC − dC u 
∆= e  S (u − d )  = e  S − S  B= e −rT  d 
   u d   u −d 

e ( r −δ ) h − d 1
p* = =
u −d 1 + eσ h

u = e ( r −δ) h +σ h d = e ( r −δ ) h −σ h
d < e ( r −δ ) h < u σ = Volatility
Alternative Binomial Trees

Cox-Ross-Rubinstein

u = eσ h
d = e −σ h

Lognormal

1 1
( r −δ − σ 2 ) h +σ h ( r −δ − σ 2 ) h −σ h
u =e 2
d =e 2

Arbitraging a Mispriced Option


• The Option is Overpriced
If we know that the option is overpriced we would like to sell it for guaranteed profit
(Arbitrage). This is achieved by selling the option and simultaneously buying a
synthetic option for the correct value.

• The Option is Under-priced


If we know that the option is under-priced we would like to buy it for guaranteed
profit (Arbitrage). This is achieved by buying the option and simultaneously selling
a synthetic option for the correct value.

Real Probability Pricing


• In reality, the expected return on a stock is α > r.
• Let p denote the true probability of an up move:
e (α−δ ) h − d
p=
u −d
• γ is the discounting rate for the option.
• Option Cost: C =e
− γh
(p C u + (1 − p) C d )
• Using γ and α yields the same option price as risk-neutral probability.
• To obtain value for γ, compute the option price, C, using risk-neutral method.
Then plug in parameters into equation below.

C e γh = S∆ e αh + B e rh

Black-Scholes Formula
General Black-Scholes Formula

C ( S , K , σ , r , t , δ ) = F P ( S ) N ( d1 ) − F P ( K ) N ( d 2 )

P ( S , K ,σ , r , t , δ ) = −F P ( S ) N ( −d1 ) + F P ( K ) N ( −d 2 )
where
 F P (S )  1 2
ln  P + σ t
 F ( K )  2 d 2 = d1 −σ t
d1 =
σ t

F P (S ) and F P (K ) are the pre-paid forward prices for the underlying


and strike assets, respectively.
Assumptions of the Black-Scholes Formula
• Continuously compounded returns on the stock are normally distributed and
independent over time.
ST
o Lognormality of .
S0
• Continuously compounded returns on the strike asset (the risk-free rate) are
known and constant.
• Volatility is known and constant.
• Dividends are known and constant.
• There are no transaction costs or taxes.
• It is possible to short-sell any amount of stock and to borrow any amount of
money at the risk-free rate.

Black-Scholes Formula for Common Stock Options


C ( S , K ,σ , r , t , δ ) = Se −δt N (d1 ) − Ke −rt N ( d 2 )

P( S , K ,σ , r , t , δ ) = −Se −δt N ( −d1 ) + Ke −rt N ( −d 2 )

where
S 1
ln   + ( r − δ + σ 2 )t
K 2 d 2 = d1 −σ t
d1 =  
σ t

F P ( S ) = Se −δt
F P ( K ) = Ke −rt
Black-Scholes Formula for Currency Options
C ( x0 , K , σ , rd , t , r f ) = x0 e
−r f t
N ( d1 ) − Ke −rd t N ( d 2 )

P ( x0 , K , σ , rd , t , r f ) = −x0 e
−r f t
N (−d1 ) + Ke −rd t N (−d 2 )

where
x  1
ln  0  + (rd − r f + σ 2 )t
K 2
d1 =  
σ t

d 2 = d1 −σ t

This is known as the Garman-Kohlhagen model.

Currency-Denomination
An option is currency-denominated if the strike price and premium are
denominated in that currency.

dollar-denominated option on euros


x0 =dollars to euros
rd =Risk Free Rate for dollars
r f =Risk Free Rate for euros

Black-Scholes Formula for Options on Futures

C ( F , K , σ , r , t ) = Fe −rt N (d1 ) − Ke −rt N (d 2 )


P( F , K ,σ , r , t ) = −Fe −rt N (−d1 ) + Ke −rt N ( −d 2 )

where
F  1
ln   + σ 2 t
K 2 d 2 = d1 −σ t
d1 =  
σ t

The pre-paid forward price for a future, is the future discounted at the risk-
free rate. δ = r

Option Greeks
∆ Delta
Delta measures the option price change when the stock price
increases by $1.
∆Call = e −δt N ( d1 ) ∆Put = −e −δt N ( −d1 )
∆Call − ∆ Put = e −δT

ΓGamma
Gamma measures the change in Delta when the stock price
increases by $1. Gamma is the convexity of the option.
d∆ d 2V
Γ= = where V is the derivative of S.
dS dS
ΓCall = ΓPut
∆ t +h − ∆ t
Γ=
ε

Vega
Vega measures the change in the option price when there is an
increase in volatility, σ , of one percentage point.
dV
Vega = * 100 where V is the derivative of S.

θ Theta
Theta measures the change in the option price when there is a
decrease in the time to maturity of one day.
dV
θ= where V is the derivative of S.
dt

ρ Rho
Rho measures the change in the option price when there is an
increase in the interest rate of one percentage point (100 basis points).
ρ = dV * 100 where V is the derivative of S.
dr

Ψ Psi
Psi measures the change in the option price when there is an
increase in the continuous dividend yield of on percentage point (100 basis
points).
dV
Ψ= * 100 where V is the derivative of S.

Option Elasticity
An option is an alternative to investing in the stock. Delta tells us the dollar risk of the
option relative to the stock: If the stock price changes by $1, by how much does the
option price change? The option elasticity, by comparison, tells us the risk of the option
relative to the stock in percentage terms: If the stock price changes by 1%, what is the
percentage change in the value of the option?

Percentage Risk of the Option


The Option Elasticity, Ω, computes the percentage change in the option price relative to
the percentage change in the stock price.
ε∆
% change in option price S∆
Ω≡ = C =
% change in stock price ε C
S

Option Volatility
σOption =σStock * Ω

Option Risk Premium


γ − r = (α − r ) * Ω where
α = Expected Stock Return
γ = Expected Option Return

Sharp Ratio
The Sharp Ratio for any asset is the ratio of the risk premium to volatility.
α −r
Sharp Ratio for Call =
σ

− (α − r )
Sharp Ratio for Put =
σ
Delta-Hedging
Overnight Profit on a Delta-Hedged Portfolio

A delta-hedged portfolio consists of selling or buying an option, buying ∆ shares


of stock, and borrowing or loaning the cash-flow.

The overnight profit has 3 components:

1. The change in the value of the option.


2. ∆ times the change in the stock price.
3. Interest on the cash-flow.
 r
 365  

Profit = {Call t =0 −Call t =1 } +{∆0 ( S1 −S 0 )} −e −1
( ∆S 0 −Call t =0 )

  

Profit = {Change in Option Value}+{∆ * Change in stock price}-{Interest}
Overnight Profit Formulas

OP = Ct − Ct +h + ∆( S t +h − S t ) − (e 365 − 1)( ∆S t − Ct )

1 
OP = −  Γε 2 + θ h + r h (∆ S − Ct )
2 

Black-Scholes Equation

1
r C (S ) = σ 2 S 2Γ + r S ∆ + θ
2
Delta-Gamma-Theta Approximation
1
Ct +h = Ct + ε ∆t + ε 2 Γt + hθ
2
where
• C ( S t +h ) =Option Cost at time t+h
• C ( S t ) = Option Cost at time t
• ε = S t +h − S t = Change in stock price from time t to time t+h
∆( S t +h ) − ∆( S t )
• Γ( S t ) =
ε
Market Making

• Market maker profitability is dependent primarily on the stock price movement.


• We define a one-standard deviation move as: σ S t h
• If the stock price moves less than one standard deviation then the market maker
profits, if the price moves one standard deviation then we break-even, finally if
the price moves more than one standard deviation then we suffer a loss.
1 1 1
• Daily h = ; Monthly h = ; Weekly h =
365 12 12
Rehedging

Let x be the number of standard deviation movements:


S −St
• xi = t +h
σ St h
Rh ,i is the period i return after a stock moves xi and rehedging is done every h.
1 2 2
• Rh ,i = σ S Γh( xi2 −1)
2
Var( Rh ,i ) = (σ S Γh )
1 2 2 2
• this is the 1/h period variance,
2
For annual variance:
h(σ 2 S 2 Γ)
1 2
AnnVar( Rh ,i ) =
2
Perpetual Options
Exotic Options
Asian Option
• An Asian option pays based on the average price.
• 3 Parameters
o Call or Put
o Geometric or Arithmetic Average
o Average Price, x = S t or Average Strike, x = K
• For an Average Price option, the payoff is based on the difference between the
strike price and the average price.
o Call Payoff = max(0, x - K) x = St
o Put Payoff = max(0, K - x )
• For an Average Strike option, there is no given strike price. The payoff is based
on the difference between the final price and the average price.
o Call Payoff = max(0, S t - x ) x =K
o Put Payoff = max(0, x - S t )
Barrier Option

• A Barrier Option has a payoff which depends on whether over the lifetime of the
option the underlying asset hits the barrier. 3 Types.

1. Knock-Out Options
 Up and Out
 Down and Out
2. Knock-In Options
 Up and In
 Down and In
3. Rebate Options
 Pays a fixed amount if barrier is hit.
 Up Rebates
 Down Rebates
• Parity Relationship for Barrier Options
Knock-In + Knock-Out = Ordinary
Compound Option

A Compound Option is an option to buy an underlying option.

 t 0 is the current time


 t 1 is the time of exercise for the Compound Option
 T is the time of exercise for the Underlying Option
 x is the strike price of the Compound Option;
o x is the price we pay for the underlying option
 The price of the underlying option at time t 1 is x = C ( S , K , T −t1 ) , we
will exercise if this option price is less than the price we would pay for the
regular option anyone could purchase.
 The price at time t 1 for a regular option that anyone could purchase is
C ( S t , K , T −t1 )

Compound Options continued…


 So then the value of the compound option at time t 1 is
max [C ( S t , K , T − t1 ) − x,0]
*
 Let S be the Critical Stock Price above which the compound option is
exercised. Then
o C ( S * , K , T − t1 ) = x
o The compound option is exercised for S t1 > S *
 Compound Option Parity
CallOnCall ( S , K , x,σ , r , t1 , t 2 , δ ) − PutOnCall ( S , K , x,σ , r , t1 , t 2 , δ ) + xe −rt1 =
BSCall ( S , K ,σ , r , t 2,δ )
CallOnPut ( S , K , x,σ , r , t1 , t 2 , δ ) − PutOnPut ( S , K , x,σ , r , t1 , t 2 , δ ) + xe −rt1 =
BSPut ( S , K ,σ , r , t 2 ,δ )
Compound Option Diagram