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Primbs, MS&E 345 1

Applications of the Return Form of

Arbitrage Pricing:
Equity Derivatives
Primbs, MS&E 345 2
Deriving Equations for Derivative Assets:
Three step algorithm:
(1) Derive factor models for returns of tradable assets.
(often involves Itos lemma.)
(2) Apply absence of arbitrage condition.
u=.l oJ)
1) Apply appropriate boundary conditions and solve.
Primbs, MS&E 345 3
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 4
Black-Scholes (Again)
Step 1: Derive factor models for returns of tradable assets.
Risk Free Asset: rdt
B
dB
!
Underlying Stock:
dz dt
S
dS
W Q =
Itos Lemma: dz Sc dt c S Sc c dc
S SS S t
W W Q = ) (
2 2
2
1
) , ( t S c
t
What is a factor model for the return on
) , ( t S c
t
Let be a security derivative to the stock.
?
dz
c
Sc
dt
c
c S Sc c
c
dc
S SS S t
W W Q

=
) (
2 2
2
1
Return:
Primbs, MS&E 345 5

c
Sc
c
c S Sc c
r
S
SS S t
W
W P P
W Q
Q
0
1
1
1
) (
1 0
2 2
2
1
Black-Scholes (Again)
Derivative: dz
c
Sc
dt
c
c S Sc c
c
dc
S SS S t
W W Q

!
) (
2 2
2
1
Step 1: Derive factor models for returns of tradable assets.
Risk Free Asset: rdt
B
dB
!
Underlying Stock:
dz dt
S
dS
W Q =
. J Q K 1 =
Step 2: Apply
Primbs, MS&E 345 6
r !
0
P
First Equation
Second Equation
W
Q
P
) (
1
r
=
Third Equation
W
Q W W Q ) ( ) (
2 2
2
1
r
c
Sc
r
c
c S Sc c
S SS S t

c
Sc
c
c S Sc c
r
S
SS S t
W
W P P
W Q
Q
0
1
1
1
) (
1 0
2 2
2
1
. JP Q K 1 ! Step 2: Apply
Black-Scholes (Again)
Primbs, MS&E 345 7
Third Equation
rc c S rSc c
SS SS t
=
2 2
2
1
W
The Black-Scholes Equation
This is for an option on a non-dividend paying asset
which follows a geometric Brownian motion.
W
Q W W Q ) ( ) (
2 2
2
1
r
c
Sc
r
c
c S Sc c
S SS S t

=

Step 3: Apply appropriate boundary condition and solve!
Black-Scholes (Again)
Primbs, MS&E 345 8
Step 3:
European Calls and Puts
rc c S rSc c
SS S t
!
2 2
2
1
W

! ) ( ) , ( K S T S c 0 ) , 0 ( = t c
rp p S rSp p
SS S t
=
2 2
2
1
W

! ) ( ) , ( S K T S p
) (
) , 0 (
t T r
Ke t p

!
Solution:
) ( ) ( ) , (
2
) (
1
d N Ke d SN t S c
t T r
!
t T
t T r K S
d

!
W
W ) )( ( ) / ln(
2
2
1
1
t d d = W
1 2
where:
) ( N
distribution function for a standard Normal (i.e. N(0,1))
) ( ) ( ) , (
1 2
) (
d SN d N Ke t S p
t T r
!

These formulas are basic...know them!!!
Primbs, MS&E 345 9
European Calls and Puts
) ( ) ( ) , (
2
) (
1
d N Ke d SN t S c
t T r
!
) ( ) ( ) , (
1 2
) (
d SN d N Ke t S p
t T r
!

We derived the equation for geometric Brownian motion.
But, the equation doesnt depend on the mean return.
The Black-Scholes formula holds even if the underlying asset
looks like:
Sdz dt t S dS W Q = ) , ( 0 ) , 0 ( = t Q and
You should check this!
Step 3:
Primbs, MS&E 345 10
75 80 85 90 95 100 105 110 115 120 125
0
5
10
15
20
25
75 80 85 90 95 100 105 110 115 120 125
0
5
10
15
20
25
30
S
S
c
p
price of call
price of put
) 25 . 0 %, 20 %, 5 , 100 ( ! ! ! ! T r K W
European Calls and Puts
) ( ) ( ) , (
2
) (
1
d N Ke d SN t S c
t T r
!
) ( ) ( ) , (
1 2
) (
d SN d N Ke t S p
t T r
!

Step 3:
Primbs, MS&E 345 11
American Calls and Puts:
We have the option to exercise early.
Hence, we only keep the option alive if:
) 0 , max( ) , ( K S t S c u for a call
) 0 , max( ) , ( S K t S p u
for a put
It is not difficult to show that early exercise of an
American call on a non-dividend paying stock is never optimal, hence it has the
same value as a European call. Early exercise for a put, however, can be optimal.
In general, we need to use numerical techniques to solve for American options.
The boundary condition given above is nasty!
Step 3:
Primbs, MS&E 345 12
Terminology:
European and American call and put options are often
referred to as plain vanilla options.
Other derivatives are then called exotics.
There are (too) many:
Binary or digital options
Barrier options
Compound options
Chooser options...
Just because they are called exotic doesnt mean they are difficult.
Often they are just a different boundary condition for the Black-Scholes equation.
Primbs, MS&E 345 13
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 14
A stock paying a continuous dividend (Merton).
Step 1: Derive factor models for returns of tradable assets.
Risk Free Asset: rdt
B
dB
!
Underlying Stock:
Sdz Sdt dS W Q !
Assume the price follows a geometric Brownian motion:
and that it also pays a continuous dividend at a rate q.
Lets think about the proper dynamics for this
Primbs, MS&E 345 15
A stock paying a continuous dividend (Merton).
Dividend: Over time dt, the dividend is qSdt.
dt
Stock price: Sdz Sdt dS W Q !
You purchase a portfolio of 1 share: value is v
t
t t dt t t dt t
S dt qS S v v dv = =

dt qS dS
t t
= dz S dt S q
t t
W Q = ) (
Dividend
S
t
v
t
=
Price
S
t+dt
+qS
t
dt = v
t+dt
dz v dt v q
t t
W Q = ) (
v
t
= S
t
Primbs, MS&E 345 16
Dividend: Over time dt, the dividend is qSdt.
dt
S
t
S
t+dt
+qS
t
dt
Stock price: Sdz Sdt dS W Q !
You purchase a portfolio of 1 share: value is v
t
dz v dt v q dv
t t t
W Q = ) (
Price
Dividend
v
t
=
= v
t+dt
A stock paying a continuous dividend (Merton).
Primbs, MS&E 345 17
An important principle:
You cannot just buy the price of the stock!!!!
You must buy a portfolio which consists of a single share!
This portfolio follows:
dz v dt v q dv
t t t
W Q = ) (
Since this is what we will purchase, it must satisfy our
absence of arbitrage conditions. The price of the stock
does not have to satisfy the conditions because it cannot
be purchased!!!! This is a very important point.
Primbs, MS&E 345 18
Note, value of the derivative depends on price of the stock S, not v!!!!
A stock paying a continuous dividend (Merton).
) , ( t S c
t
Let be a security derivative to the stock price.
dz
c
Sc
dt
c
c S Sc c
c
dc
S SS S t
W W Q

=
) (
2 2
2
1
By Itos lemma, its return is:
Risk Free Asset:
rdt
dB
=
Underlying Asset Price:
dz dt
S
dS
W Q ! Dividend rate: q
Value dynamics:
dz dt q
v
dv
W Q = ) (
Primbs, MS&E 345 19
A stock paying a continuous dividend (Merton).
Now we have models of returns for our tradable assets.
Go to Step 2: Apply . JP Q K 1 !
Risk Free Asset:
rdt
B
dB
=
Underlying Asset Price:
dz dt
S
dS
W Q ! Dividend rate: q
Value dynamics:
dz dt q
v
dv
W Q = ) (
Derivative:
dz
c
Sc
dt
c
c S Sc c
c
dc
S SS S t
W W Q

=
) (
2 2
2
1
Primbs, MS&E 345 20

c
Sc
c
c S Sc c
q
r
S
SS S t
W
W P P
W Q
Q
0
1
1
1
) (
1 0
2 2
2
1
Return form of AOA: . J Q K 1 =
r =
0
P
First Equation
Second Equation
W
Q
P
) (
1
r q
=
Third Equation
W
Q W W Q ) ( ) (
2 2
2
1
r q
c
Sc
r
c
c S Sc c
S SS S t

!

Primbs, MS&E 345 21
Third Equation
rc c S Sc q r c
SS S t
!
2 2
2
1
) ( W
This is for a derivative on a stock paying a continuous dividend.
W
Q W W Q ) ( ) (
2 2
2
1
r q
c
Sc
r
c
c S Sc c
S SS S t

=

This is the only difference from Black-Scholes.
Step 3: Apply appropriate boundary condition and solve!
Primbs, MS&E 345 22
This is the only change.
European Calls and Puts
rc c S Sc q r c
SS S t
=
2 2
2
1
) ( W

= ) ( ) , ( K S T S c 0 ) , 0 ( = t c
rp p S Sp q r p
SS S t
=
2 2
2
1
) ( W

! ) ( ) , ( S K T S p
) (
) , 0 (
t T r
Ke t p

!
t T
t T q r K S
d

!
W
W ) )( ( ) / ln(
2
2
1
1
Solution:
) ( ) ( ) , (
2
) (
1
) (
d N Ke d N Se t S c
t T r t T q
!
t d d ! W
1 2
where:
) ( N
distribution function for a standard Normal (i.e. N(0,1))
) ( ) ( ) , (
1
) (
2
) (
d N Se d N Ke t S p
t T q t T r
!

These formulas are basic...know them!!!
Step 3:
Primbs, MS&E 345 23
Which assets pay continuous dividends?
A stock index
Foreign currencies
Commodities with a convenience yield
Step 3:
Primbs, MS&E 345 24
Do dividends make an option more or less valuable?
0 0. 01 0. 02 0. 03 0. 04 0. 05 0. 06 0. 07 0. 08 0. 09 0. 1
3. 2
3. 4
3. 6
3. 8
4
4. 2
4. 4
4. 6
4. 8
5
0 0. 01 0. 02 0. 03 0. 04 0. 05 0. 06 0. 07 0. 08 0. 09 0. 1
3. 2
3. 4
3. 6
3. 8
4
4. 2
4. 4
4. 6
4. 8
q q
c
p
call
put
) 25 . 0 %, 20 %, 5 , 100 ( ! ! ! ! T r K W
Step 3:
Dividends bleed away the price...
Primbs, MS&E 345 25
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 26
A stock paying a cash dividend.
Step 1: Derive factor models for returns of tradable assets.
Risk Free Asset: rdt
B
dB
!
Underlying Stock:
Pays a cash dividend of D
X
at time X.
dz v dt v dv
t t t
W Q !
We model the value of a share as being continuous.
On the other hand, the price drops when the stock goes ex-dividend.
X
D
X
dz S dt t D S dS
t t t
W X H Q
X
= )) ( (
Primbs, MS&E 345 27
Risk Free Asset:
rdt
B
dB
=
Underlying Asset Price:
Value dynamics:
dz dt
v
dv
W Q =
Note, value of the derivative depends on price of stock S, not v!!!!!!
A stock paying a cash dividend.
) , ( t S c
t
Let be a security derivative to the stock price.
dz
c
Sc
dt
c
t t S c t S c c S Sc c
c
dc
S t t
SS S t
W
X H W Q
X

!

) ( )) , ( ) , ( ( ) (
2 2
2
1
By Itos lemma, its return is:
dz S dt t D S dS
t t t
W X H Q
X
= )) ( (
Primbs, MS&E 345 28
Risk Free Asset:
rdt
B
dB
=
Value dynamics:
dz dt
v
dv
W Q =
A stock paying a cash dividend.
dz
c
Sc
dt
c
t t S c t D S c c S Sc c
c
dc
S t t
SS S t
W
X H W Q
X

=

) ( )) , ( ) , ( ( ) (
2 2
2
1
Derivative:
. JP Q K 1 ! Step 2: Apply

c
Sc
c
t t S c t S c c S Sc c
r
S
t t
SS S t
W
W P P
X H W Q
Q
X
0
1
1
1
) ( )) , ( ) , ( ( ) (
1 0
2 2
2
1
Primbs, MS&E 345 29
A stock paying a cash dividend.
r !
0
P
First Equation
Second Equation
W
Q
P
) (
1
r
=
Third Equation
W
Q W
X H W Q
X
) (
) ( )) , ( ) , ( ( ) (
2 2
2
1
r
c
Sc
r
c
t t S c t D S c c S Sc c
S t t
SS S t

=

. J Q K 1 =
Step 2: Apply

c
Sc
c
t t S c t S c c S Sc c
r
S
t t
SS S t
W
W P P
X H W Q
Q
X
0
1
1
1
) ( )) , ( ) , ( ( ) (
1 0
2 2
2
1
Primbs, MS&E 345 30
A stock paying a cash dividend.
Third Equation
rc t t S c t S c c S rSc c
t t
SS S t
!

) ( )) , ( ) , ( (
2 2
2
1
X H W
X
This is for an option on a stock paying a lump (cash) dividend.
Step 3: Apply appropriate boundary condition and solve!
W
Q W
X H W Q
X
) (
) ( )) , ( ) , ( ( ) (
2 2
2
1
r
c
Sc
r
c
t t S c t D S c c S Sc c
S t t
SS S t

=

Primbs, MS&E 345 31
Step 3:
For European options, only the value of S at time matters:
T
S
D
So, you can just act like the stock started at a lower price
and there were no dividends!
x
x
X
Primbs, MS&E 345 32
For European options, only the value of S at time matters:
So, you can just act like the stock started at a lower price
and there were no dividends!
T
S
De
-r
x
x
X r
e S S

!
~
X
Step 3:
Primbs, MS&E 345 33
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 34
Remember this!

c
fc
c
c f fc c
r
f
ff f t
W
W P P
W Q
Q
0
1
0
1
) (
1 0
2 2
2
1
Derivative:
dz
c
fc
dt
c
c f fc c
c
dc
f ff f t
W W Q

!
) (
2 2
2
1
Options on Futures (Black,1976)
Step 1: Derive factor models for returns of tradable assets.
Risk Free Asset: rdt
B
dB
!
Step 2: Apply AOA but for futures!
Underlying Future:
dz dt
f
df
W Q !
Primbs, MS&E 345 35
r !
0
P
First Equation
Second Equation
W
Q
P !
1
Third Equation
W
Q
W W Q

!

c
fc
r
c
c f fc c
f ff f t
) (
2 2
2
1
. JP Q K 1 ! Step 2: Apply

c
fc
c
c f fc c
r
f
ff f t
W
W P P
W Q
Q
0
1
0
1
) (
1 0
2 2
2
1
Primbs, MS&E 345 36
Third Equation
rc c f c
ff t
=
2 2
2
1
W
The Black-Scholes Equation for an option on a futures contract.
W
Q
W W Q

=

c
fc
r
c
c f fc c
f ff f t
) (
2 2
2
1
Primbs, MS&E 345 37
Step 3:
It looks like the equation for an option on an asset that pays
a continuous dividend, except here the continuous dividend
rate is the risk free rate!
Hence, we have closed form solutions!
Solution:
) ( ) ( ) , (
2
) (
1
) (
d N Ke d N fe t f c
t T r t T r
!
t
t K f
d

!
W
W ) )( ( ) / ln(
2
2
1
1
t d d = W
1 2
where:
) ( N
distribution function for a standard Normal (i.e. N(0,1))
) ( ) ( ) , (
1
) (
2
) (
d N fe d N Ke t f p
t T r t T r
!

Primbs, MS&E 345 38
In some ways Blacks model is more fundamental then the other
models we have seen. (recall our analysis of market price of risk.)
If you can price futures contracts in terms of spot prices, then
you can use Blacks formula to derive all our previous formulas.
As an exercise, you should try this for assets paying a continuous
or cash dividends.
Blacks model is also useful for a number of interest rate derivatives.
We will see this later...
Step 3:
Primbs, MS&E 345 39
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 40
Assets with Poisson Jumps (Cox and Ross, 1976)
Derivative: T
Q
d
c
t S c t kS c
dt
c
Sc c
c
dc
t t S t
) , ( ) , (
) (

!
Be careful. Should set the mean of dT to 0. This doesnt
matter in the current setting, but it can matter in other
settings.
Bond: rdt
B
dB
=
Asset price:
T Q d k dt
S
dS
) 1 ( =
Pdt
1-Pdt
1
0 0
dT
Lets do it anyway...
Primbs, MS&E 345 41
Assets with Poisson Jumps (Cox and Ross, 1976)
Bond:
Asset price:
) )( 1 ( )) 1 ( ( dt d k dt k
S
dS
P T P Q =
Derivative:
rdt
B
dB
=
) (
) , ( ) , (
)) , ( ) , ( ( ) (
dt d
c
t S c t kS c
dt
c
t S c t kS c Sc c
c
dc
t t S t
P T
P Q

c
t S c t kS c
k
c
t S c t kS c Sc c
k
r
S t
) , ( ) , (
1
0
1
1
1
)) , ( ) , ( ( ) (
) 1 (
1 0
P P
P Q
P Q
. JP Q K 1 = Step 2: Apply
Primbs, MS&E 345 42
r !
0
P
First Equation
. JP Q K 1 ! Step 2: Apply

c
t S c t kS c
k
c
t S c t kS c Sc c
k
r
S t
) , ( ) , (
1
0
1
1
1
)) , ( ) , ( ( ) (
) 1 (
1 0
P P
P Q
P Q
Second Equation
P
Q
P

=
1
1
k
r
Confusing
Notation!!
Third Equation
c
t S c t kS c
k
r
r
c
t S c t kS c Sc c
S t
) , ( ) , (
1
)) , ( ) , ( ( ) (

!

P
Q P Q
Primbs, MS&E 345 43
Third Equation
c
t S c t kS c
k
r
r
c
t S c t kS c Sc c
S t
) , ( ) , (
1
)) , ( ) , ( ( ) (

!

P
Q P Q
) ))( , ( ) , ( ( ) 1 )( ( r t S c t kS c k rc Sc c
S t
! Q Q
This is a partial differential/difference equation.
Step 3: Apply appropriate boundary condition and solve!
Note the non-local nature of the equation due to jumps
Primbs, MS&E 345 44
Closed form solution for a European Call Option:
Looks a lot like the Black-Scholes formula but with Poisson
) / , ( ) , ( ) , (
) (
k y x Ke y x S t S c
t r
= = =

where

g
=

= =
E
F
F
F E
i
i
i
e
!
) , (
1
) )( (

!
k
k t T r
y
Q
and x is the smallest nonnegative integer greater than:
) ln(
) ( ) / ln(
k
t T S K Q
Step 3:
Primbs, MS&E 345 45
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 46
Mertons Jump Diffusion Model (1976):
Call option:

=

dt
c
t S c t YS c E
d
c
t S c t YS c
dz
c
Sc
dt
c
t S c t YS c E
c
c S Sc c
c
dc
t t
S SS S t
P T
W P W Q
)] , ( ) , ( [
) , ( ) , (

)]) , ( ) , ( [ ( ) (
2 2
2
1
Bond:
rdt
B
dB
=
Asset price:
) ] 1 [ ) 1 (( ]) 1 [ ( dt Y E d Y dz dt Y E
S
dS
= P T W P Q
Pdt
1-dt
Y-1
0 0
dt
dT
Step 1:
Primbs, MS&E 345 47
Mertons Jump Diffusion Model (1976):

dt
c
t S c t YS c E
d
c
t S c t YS c
P T
)] , ( ) , ( [ ) , ( ) , (
Merton makes a big assumption:
Put another way, the jump risk has zero beta.
We know that this also means:
2
and
1
are zero!
) ] 1 [ ) 1 (( dt Y E d Y P T

1
0
0
0
1
0 0
1
1
1
)]) , ( ) , ( [ ( ) (
] 1 [
3 2 1 0
2 2
2
1
P P
W
W P P
P W Q
P Q
c
Sc
c
t S c t YS c c S Sc c
Y
r
S
SS S t
Step 2:
All risk associated with the jump component is diversifiable.
Primbs, MS&E 345 48
Mertons Jump Diffusion Model (1976):

c
Sc
c
t S c t YS c c S Sc c
Y
r
S
SS S t
W
W P P
P W Q
P Q
0
1
1
1
)]) , ( ) , ( [ ( ) (
] 1 [
1 0
2 2
2
1
Step 2:
r =
0
P
First Equation
Second Equation
W
P Q
P
r Y
!
] 1 [
1
Third Equation
c
Sc r Y
r
c
t S c t YS c
c
c S Sc c
S SS S t
W
W
P Q P W Q ) ] 1 [ ( )]) , ( ) , ( [ ( ) (
2 2
2
1

!

Primbs, MS&E 345 49
c
Sc r Y E
r
c
t S c t YS c E
c
c S Sc c
S SS S t
W
W
P Q P W Q ) ] 1 [ ( )]) , ( ) , ( [ ( ) (
2 2
2
1

=

Third Equation:
S SS S t
Sc r Y rc t S c t YS c c S Sc c ) ] 1 [ ( )]) , ( ) , ( [ ( ) (
2 2
2
1
! P Q P W Q
Step 3: Apply appropriate boundary condition and solve!
)]) , ( ) , ( [ ( ]) 1 [ (
2 2
2
1
t S c t YS c rc c S Sc Y r c
SS S t
! P W P
Primbs, MS&E 345 50
When Y is lognormal, there is a closed form solution for a call option

g
!
d

d
!
0
) (
!
)) ( (
) , (
n
n
n t T
f
n
t T e
t S c
P
P
where
) 1 ( k ! dP P
and
n
f is the Black-Scholes formula with
volatility
) (
2
2
t
n

H
W
risk-free rate
) ( t T
n
k r

K
P
H the standard deviation of ) ln(Y
) 1 ln( k ! K
] 1 [ ! Y k
Messy...but at least we can calculate it.
Primbs, MS&E 345 51
An easy special case:
Complete bankruptcy:
0 ! Y
Question: Does bankruptcy make an option worth more or less?
)]) , ( ) , ( [ ( ]) 1 [ (
2 2
2
1
t S c t YS c E rc c S Sc Y E r c
SS S t
= P W P
Mertons formula reduces from:
c r c S Sc r c
SS S t
) ( ) (
2 2
2
1
P W P !
to:
The Black-Scholes equation with risk free rate: rP
Primbs, MS&E 345 52
Option Prices versus the Risk Free Rate
0. 02 0. 03 0. 04 0. 05 0. 06 0. 07 0. 08 0. 09 0. 1 0. 11 0. 12
4. 2
4. 4
4. 6
4. 8
5
5. 2
5. 4
5. 6
5. 8
r
c
Call Option
0. 02 0. 03 0. 04 0. 05 0. 06 0. 07 0. 08 0. 09 0. 1 0. 11 0. 12
2. 6
2. 8
3
3. 2
3. 4
3. 6
3. 8
4
r
Put Option
p
) 25 . 0 %, 20 , 100 ( ! ! ! T K W
Primbs, MS&E 345 53
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 54
Stochastic Volatility (Hull and White)
Risk Free Asset:
rdt
B
dB
=
Underlying Asset Price:
1
dz v dt
S
dS
! Q
Volatility is random:
2
dt dz dz E V ! ] [
2 1
Derivative:
) , , ( t v S c by Itos lemma:
2 1
2
2
1
2
2
1
) (
dz
c
bc
dz
c
Sc v
dt
c
Sc v b c b c vS ac Sc c
c
dc
v S Sv vv SS v S t

!
V Q
Step 1:
Primbs, MS&E 345 55

c
bc
c
Sc v
v
c
Sc v b c b vSc ac Sc c
r
v
S
Sv vv SS v S t
0
0 0
1
1
1
) (
2 1 0
2
2
1
2
1
P P P
Q
Q
r !
0
P
First Equation
Second Equation
v
r
!
Q
P
1
Third Equation
rc Sc v b c b vSc c b a rSc c
Sv vv SS v S t
= ) ) ( (
2
2
1
2
1
2
P
Where P
2
is the market price of risk for the volatility factor.
Stochastic Volatility (Hull and White)
Step 2:
I wont go into solutions of this equation...
Primbs, MS&E 345 56
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 57
Option to exchange one asset for another (Margrabe, 1978)
Risk Free Asset:
rdt
B
dB
=
Asset 1:
1 1 1
1
1
dz dt
S
dS
W Q =
dt dz dz E = ] [
2 1
Asset 2:
2 2 2
2
2
dz dt
S
dS
W Q =
Derivative:
) , , (
2 1
t S S c
by Itos lemma:
2
2 2
1
1 1 2 1 2 1
2
2
2
2 2
1
2
1
2
1 2
1
2 2 1 1
2 1 2 1 2 2 1 1 2 1
) (
dz
c
c S
dz
c
c S
dt
c
c S S c S c S c S c S c
c
dc
S S S S S S S S S S t
W W W VW W W Q Q

!
Step 1:
Primbs, MS&E 345 58
r !
0
P
First Equation
Second Equation
1
1
1
W
Q
P
r
=

c
c S
c
c S
c
c S S c S c S c S c S c
r
S
S
S S S S S S S S t
2
1
2 1 2 2 1 1 2 1
2 2
2
2
1 1
1
1 0
2 1 2 1
2
2
2
2 2
1
2
1
2
1 2
1
2 2 1 1
2
1
0
0
0
0
1
1
1
1
) (
W
W
P
W
W
P P
W VW W W Q Q
Q
Q
Third Equation
2
2
2
W
Q
P
r
=
rc c S S c S c S c rS c rS c
S S S S S S S S t
= ) (
2 1 2 2 1 1 2 1
2 1 2 1
2
2
2
2 2
1
2
1
2
1 2
1
2 1
W W W W
Fourth Equation
Option to exchange one asset for another (Margrabe, 1978)
Step 2:
Primbs, MS&E 345 59
Solution:
) ( ) ( ) , , (
2 1 1 2 2 1
d N S d N S t S S c !
t
t S S
d

!
W
W ) )( ( ) / ln(
2
2
1
1 2
1
t d d = W
1 2
where:
) ( N
distribution function for a standard Normal (i.e. N(0,1))
2 1
2
2
2
1
2 W W W W W =
Step 3:
Option to exchange one asset for another (Margrabe, 1978)
) 0 , max( ) , , (
1 2 2 1
S S S S c =
If you have the option to exchange asset S
2
for asset S
1
at time T
this leads to the boundary condition:
2 2
) , , 0 ( S t S c = 0 ) , 0 , (
1
= t S c
Looks a lot like Black Scholes.
Primbs, MS&E 345 60
Step 3:
Option to exchange one asset for another (Margrabe, 1978)
) 0 , max( ) , , (
1 2 2 1
S S T S S c !
A touch of intuition:
) 0 , 1 max(
1
2
1
!
S
S
S
We are measuring S
2
in units of S
1
.
This in known as a change of numeraire.
We will see this trick later...
Looks like a call option on S
2
/S
1
with strike 1.
By the way, can a standard call option be seen as exchanging one
asset for another?
Primbs, MS&E 345 61
Black-Scholes
Poisson
(Cox and Ross)
Jump diffusion model
(Merton)
Dividends
Options on futures
(Black)
Multiple factors
Stochastic Volatility
(Hull and White)
Exchange one asset
for another (Margrabe)
Option on Max, Min
Option on an average
(Asian options)
Path Dependent
Primbs, MS&E 345 62
Path Dependence:
Some derivatives depend on the path of the underlying asset.
Payoff: ) 0 , max(
0
1

T
t T T
dt S S
A specific example is the Average strike option.
So, ) , , (
0
t d S S c
t
t

X
X
We need to write an Ito equation for this.
The dependence on the entire path is a problem!
For example: An Asian option depends on the average price
of the underlying stock over a given time period.
Primbs, MS&E 345 63
The problem is the

t
d S
0
X
X
term
The general approach is to try to capture the path dependence
with another variable.
Now we can apply Itos lemma and continue in typical fashion...
Path Dependence:
Lets see how this would work for an Asian option

!
t
t
d S I
0
X
X
then
dt S dI
t t
!
Lets assign:
) , , ( ) , , (
0
t I S c t d S S c
t t
t
t
!

X
X
So where S and I are Ito processes
Primbs, MS&E 345 64
Asset price:
dz dt
S
dS
W Q =
Bond: rdt
B
dB
=
Path Dependence:

t
t
d S I
0
X
X
dt S dI
t t
= Path Dependence
Derivative:
dz
c
Sc
dt
c
c S Sc Sc c
c
dc
S SS I S t
W W Q

=
) (
2 2
2
1
) , , ( t I S c
Primbs, MS&E 345 65
. JP Q K 1 ! Step 2: Apply
Path Dependence:

c
Sc
c
c S Sc Sc c
r
S
SS I S t
W
W P P
W Q
Q
0
1
1
1
) (
1 0
2 2
2
1
rc c S Sc rSc c
SS I S t
!
2 2
2
1
W
W
Q W W Q ) ( ) (
2 2
2
1
r
c
Sc
r
c
c S Sc Sc c
S SS I S t

!

Primbs, MS&E 345 66
Path Dependence:
rc c S Sc rSc c
SS I S t
!
2 2
2
1
W
For an average strike Asian option, the boundary condition is
) 0 , max( ) , , ( I S I S c = 0 ) , , 0 ( = t I c
We can pull the same sort of trick for other path dependence:
We can even handle ]) , 0 [ , max( t S M
t
= X
X
Since it is the limit of
n
t
n
n
t
d S
1
0
lim

g p
X
X
Primbs, MS&E 345 67
Path Dependence:
I wont expand on this now since we will see another
approach to this later in the course...
We can even handle ]) , 0 [ , max( t S M
t
= X
X
Since it is the limit of
n
t
n
n
t
d S M
1
0
lim

g p
X
X
You can derive that: Mdt
M
S
n
dM
n

!
1
0
So, and option on a max solves the Black-Scholes equation, but
the boundary conditions are different.
Primbs, MS&E 345 68
Summary of Return Form Approach:
Three step algorithm:
(1) Derive factor models for returns of tradable assets.
(often involves Itos lemma.)
(2) Apply absence of arbitrage condition.
(u=.l oJ)
(3) Apply appropriate boundary conditions and solve.
(how to solve is your problem.)
Primbs, MS&E 345 69
References
Merton, R. C., Option pricing when underlying stock returns are discontinuous, Journal of Financial
Economics, 3 (1976) 125-144.
Cox, J. C. and S. A. Ross, The valuation of options for alternative stochastic processes, Journal of
Financial Economics, 3 (1976) 145-166.
Black, F., The pricing of commodity contracts, Journal of Financial Economics, 3 (1976) 167-179.
Merton, R. C., Theory of rational option pricing, Bell Journal of Economics and Management Science, 4
(1973) 141-183.
Black, F. and M. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy,
81 (1973) 637-659.
Margrabe, W., The value of an option to exchange one asset for another, Journal of Finance, 33(1)
(1978) 177-186.
Hull, J. C., Options, Futures, and Other Derivatives, 3
rd
Edition, Prentice Hall, 1997.
Wilmott, P. Paul Wilmott on Quantitative Finance, Volume 1 and 2, Wiley, 2000.