6.

1a Black-Scholes-Merton Formulas
• The Black–Scholes– Merton formulas are useful in pricing European call and
put options.
European call price
= −

Lecture 6 Stock price at time zero

Continuously compounded risk-free rate

The Black-Scholes-Merton Model Strike price

Base of the natural log function
Time to maturity of the option
It is measured as the number of trading days
and The Greek Letters left in the life of the option divided by 252.
= − − −
Chapter 15 & 19 Hull. Options, futures and other derivatives. Pearson. European put price
FINA 4110 (Dr. Edwin Mok) Lecture 6 2

6.1a Black-Scholes-Merton Formulas 6.1a Black-Scholes-Merton Formulas

Stock price volatility = − = −

Cumulative probability distribution function for
a variable with a standard normal distribution.
ln / + + ln / + −
2 2
d = d = − d =
= − − −
It is the probability that a variable with a
standard normal distribution will be less than x.
= − − −
Natural logarithm function X = 1.65
FINA 4110 (Dr. Edwin Mok) Lecture 6 3 FINA 4110 (Dr. Edwin Mok) Lecture 6 4
 6.1a Black-Scholes-Merton Formulas 6.1a Black-Scholes-Merton Formulas
The term N(d2) can be interpreted as the
probability that a call option will be exercised.

= − 0.95 = −
Cumulative probability distribution function for Cumulative probability distribution function for
a variable with a standard normal distribution. a variable with a standard normal distribution.

= − − − = − − −
It is the probability that a variable with a It is the probability that a variable with a
standard normal distribution will be less than x. standard normal distribution will be less than x.

X = 1.65
FINA 4110 (Dr. Edwin Mok) Lecture 6 5 FINA 4110 (Dr. Edwin Mok) Lecture 6 6

6.1a Black-Scholes-Merton Formulas 6.1a Black-Scholes-Merton Formulas

When the stock price becomes very large… When the stock price becomes very large…
In this case N(d1) and N(d2) become close to 1, = − . In this case N(-d1) and N(-d2) become close to 0, = 0.

A call option is almost certain to be exercised! A put option is almost certain to be not exercised!
Call option then becomes very similar to a forward contract with delivery price K. Put option becomes worthless!
1 1 0 0
= − = − − −
ln / + + ln / + − ln / + + ln / + −
2 2 2 2
d = d = d = d =

FINA 4110 (Dr. Edwin Mok) Lecture 6 7 FINA 4110 (Dr. Edwin Mok) Lecture 6 8
Q1. Black-Scholes-Merton Pricing Formulas Q1. Black-Scholes-Merton Pricing Formulas
The stock price 6 months from the expiration of an option is $42, the exercise The stock price 6 months from the expiration of an option is $42, the exercise price
price of the option is $40, the risk-free interest rate is 10% per annum, and the of the option is $40, the risk-free interest rate is 10% per annum, and the volatility is
volatility is 20% per annum. 20% per annum.
a. What is the value of a call option? b. What is the break-even point of the call option?
Investment Return
$% !.%%
! /" # #% ' /' # . # % × .)
• To break even, c = S −
1. d = &
=
. .)
= 0.7693
!.%%
' /' # . × .)
2. d = %
= 0.6278 • c =S +∆ −
. .)
1
. (2%)
3. = 40 = 38.0492 • ∆S = c + K − S = 4.76 + 40 − 42 = 2.26
4. = 0.7693 = 0.7791 & − = −0.7693 = 0.2209
5. = 0.6278 = 0.7349 & − = −0.6278 = 0.2651 • The stock price has to rise by $2.76 for the purchaser of the call to break even.
6. = − = 42 × 0.7791 − 38.0492 × 0.7349 = 4.7594
FINA 4110 (Dr. Edwin Mok) Lecture 6 9 FINA 4110 (Dr. Edwin Mok) Lecture 6 10

Q1. Black-Scholes-Merton Pricing Formulas 6.1c Black-Scholes-Merton Formulas

The stock price 6 months from the expiration of an option is $42, the exercise price • Employee stock options (warrants) are different from regular call options in
of the option is $40, the risk-free interest rate is 10% per annum, and the volatility that exercise leads to the company issuing more shares and then selling them
is 20% per annum. to the option holder for the strike price.
c. What is the value of a put option? Assume that there are no compensating
The company has N The value of the benefits, the value of the company should
• = − − − = 38.0492 × 0.2651 − 42 × 0.2209 = 0.8086 shares worth S0 each. company today is NS0.not change as a result of the issue.

per share MK new funding

d. What is the break-even point of the put option? Each option giving the
holder the right to buy
• To break even, p = K − S , = K − S − ∆ <= ∆S = K − S − = 40 − 42 − one share for K.
0.81 = −2.81
The number of new options
M new options
• The stock price has to fall by $2.81 for the purchaser of the put to break even. contemplated is M.
FINA 4110 (Dr. Edwin Mok) Lecture 6 11 FINA 4110 (Dr. Edwin Mok) Lecture 6 12
 6.1c Black-Scholes-Merton Formulas 6.1c Black-Scholes-Merton Formulas
• Suppose that without the warrant issue the share price will be ST at the
warrant’s maturity.

The share price immediately This means that the value of the
C∗A
after exercise becomes: company at time T will be NST. The reduction in the stock price is −∆ = .
?

∗ ? @ #A"
= per share MK new funding Therefore, the total cost of the
?#A
?
options is ∗ B = × × B.
The payoff to an option holder: ?#A
Value of new Value of existing
∗ ? #A" The value of the company
− = @ − call option call option
?#A increases to: NST + MK.
?
Thus, the value of each employee option (c*) is
∗ ∗ ?#A
− = ( − ) − = ( − )
+B +B of the value of regular call option.
FINA 4110 (Dr. Edwin Mok) Lecture 6 13 FINA 4110 (Dr. Edwin Mok) Lecture 6 14

Q2. Employee Stock Options Q2. Employee Stock Options

A company with 1 million shares worth $40 each is considering issuing 200,000 A company with 1 million shares worth $40 each is considering issuing 200,000
warrants each giving the holder the right to buy one share with a strike price of warrants each giving the holder the right to buy one share with a strike price of
$60 in 5 years. It wants to know the cost of this. The interest rate is 3% per $60 in 5 years. It wants to know the cost of this. The interest rate is 3% per
annum, and the volatility is 30% per annum. The company pays no dividends. annum, and the volatility is 30% per annum. The company pays no dividends.
What is the expected decline in stock price after the issue? What is the expected decline in stock price after the issue?
The stock price will
The reduction in the stock price: decline to $38.8266.
• The value of a 5-year European call option on the stock is $7.0419. C∗A , GE,EGE
−∆ = = = $1.1734.
$% !.F% ? , ,
! /" # #% ' /D # . E# % ×)
•d = = = −0.0454 Value of new
& .E ) Value of existing
!.F% call option
' /D # . E %
×) call option
•d = = −0.7162 The total cost of the warrant issue:
.E )
• = −0.0454 = 0.4819 & = −0.7162 = 0.2369 ∗×B =
1,000,000
• = − = 40 × 0.4819 − 60 . E ) × 0.2369 = 7.0419 5.8669 = (7.0419) 5.86669 × 200,000 = $1,173,373.
1,000,000 + 200,000
.
FINA 4110 (Dr. Edwin Mok) Lecture 6 15 FINA 4110 (Dr. Edwin Mok) Lecture 6 16
 6.2a Implied Volatilities 6.2a Implied Volatilities
• The one parameter in the Black–Scholes–Merton pricing formulas that cannot be • Suppose that c = 1.875 when S0 = 21, K = 20, r = 0.1, and T = 0.25.
directly observed is the volatility of the stock price. • The implied volatility is the value of that gives c = 1.875.

= − • It is not possible to get with an equation that is expressed as a function of S0, K, r,

Option Info
T, and c.
Market Price
ln / + +
2
d = • Instead, an iterative search procedure can be used to find the implied .

1.875 = 21 × − 20 × . × . )
• Implied volatilities are the volatilities implied by option prices traded in the market.

ln 21/20 + 0.1 + × 0.25

2
d =
0.25
FINA 4110 (Dr. Edwin Mok) Lecture 6 17 FINA 4110 (Dr. Edwin Mok) Lecture 6 18

6.2b Implied Volatilities 6.2b Implied Volatilities

c c
Next by trying a value of 0.30 for .
This gives a value of c equal 2.10
to 1.76, which is too low. This gives a value of c equal
to 2.10, which is too high.
1.875 1.875
1.76 1.76

Start by trying = 0.20.

σ σ
0.20 ??? 0.20 ??? 0.30
As c is an increasing function of , a higher value of is required. It means that must lie between 0.20 and 0.30.
FINA 4110 (Dr. Edwin Mok) Lecture 6 19 FINA 4110 (Dr. Edwin Mok) Lecture 6 20
 6.2b Implied Volatilities 6.2b Implied Volatilities
c c
This also proves to be too high. A value of 0.25 can be tried for . Proceeding in this way, we can halve the range for at each iteration.
2.10 2.10
1.9xx 1.9xx
1.875 1.875
1.76 1.76

The correct value of can be

calculated to any required accuracy.

σ σ
0.20 ??? 0.25 0.30 0.20 ??? 0.25 0.30
It shows that lies between 0.20 and 0.25. In this example, the implied volatility is 0.235, or 23.5%, per annum.
FINA 4110 (Dr. Edwin Mok) Lecture 6 21 FINA 4110 (Dr. Edwin Mok) Lecture 6 22

6.2c Implied Volatilities 6.2c Implied Volatilities

• Whereas historical volatilities are backward looking, implied volatilities are • The implied volatility is easier to make relative valuation than the option price.
forward looking.
• The implied volatilities of actively traded options can be used by traders to
• Traders often quote the implied volatility of an option rather than its price. estimate appropriate implied volatilities for other derivatives.
σ=0.22 Option A

σ=0.22 σ=0.32 σ=0.26 Option B

σ=0.28 Option C
Historical volatilities Implies volatilities

σ Actively Traded Options σ=0.30

0 T
FINA 4110 (Dr. Edwin Mok) Lecture 6 23 FINA 4110 (Dr. Edwin Mok) Lecture 6 24
 6.2d Implied Volatilities 6.2d Implied Volatilities
• The SPX VIX is an index of the implied volatility of 30-day options on the S&P • A trader buys a futures contract on the VIX when the futures price is 18.5 and
500 calculated from a wide range of calls and puts. closes out the contract when the futures price is 19.3.
• One contract is on 1,000 times the index.
• An index value of 15 indicates that the implied volatility of 30-day options on • The trader makes a gain of $800.
the S&P 500 is estimated as 15%.
• A futures or options contract on the VIX is a bet only on volatility.
• It is sometimes referred to as the ‘‘fear factor.’’ • By contrast, a trade involving futures or options on the S&P 500 is a bet on
VIX
both the future level of the S&P 500 and the volatility of the S&P 500.
S&P500
Sell Sell
Implied +$800
Options VIX Index
Volatilities Buy Buy
Call Put 15% 15 t
t
FINA 4110 (Dr. Edwin Mok) Lecture 6 25 FINA 4110 (Dr. Edwin Mok) Lecture 6 26

6.2d Implied Volatilities 6.3a Dividends

It reached 30 during the second half of 2007 and a record 80 in October and • We modify the Black–Scholes–Merton model to take account of dividends.
November 2008 after Lehman’s bankruptcy.

A riskless component that corresponds to the

known dividends during the life of the option

On this date the stock price declines

The stock price is the PV(Dividends) by the amount of the dividend.
sum of two components:
By early 2010, it had declined A risky
to a more normal levels. component
t
0 Ex-day T
Between 2004 and mid-2007 it tended to stay between 10 and 20. The date on which the dividend is paid should be assumed to be the ex-dividend date.
FINA 4110 (Dr. Edwin Mok) Lecture 6 27 FINA 4110 (Dr. Edwin Mok) Lecture 6 28
 6.3a Dividends 6.3b Dividends
• This means that the Black-Scholes-Merton formulas can be used if • Consider a European call option on a stock when there are ex-dividend dates
in two months and five months. The dividend on each ex-dividend date is
expected to be $0.50. The current share price is $40, the exercise price is $40,
the stock price volatility is 30% per annum, the risk-free rate of interest is 9%
The stock price is reduced by the present value per annum, and the time to maturity is six months.
of the dividends during the life of the option
$40
0.5 . I×
-$0.9742 )
PV(Dividends) 0.5 . I×
∗
$39.0258
A risky
component
t t
0 Ex-day T 0 2m 5m 6m
Discounting
The discounting being done from the ex-dividend dates at the risk-free rate.
FINA 4110 (Dr. Edwin Mok) Lecture 6 29 FINA 4110 (Dr. Edwin Mok) Lecture 6 30

6.3b Dividends 6.4a Delta

• = 39.0258, = 40, = 0.09, = 0.3, JK = 0.5. • The delta (∆) of an option is defined as the rate of change of the option price
with respect to the price of the underlying asset.
$% !.F%
Option Price
! /" # #% EI. )L/' # . I# % × .)
•d = = = 0.2020 ∆=N /N , where c is the price of the
& .E .)
Suppose that the delta of a call option and S is the stock price.
call option on a stock is 0.6.
EI. )L/' # . I
!.F%
× .)
+$1.2
•d =
%
= −0.0102 M It is the slope of the curve that relates the
.E .)
option price to the underlying asset price.

• = 0.2020 = 0.5800 & = −0.0102 = 0.4959 Stock Price

+$2.0
• = − = 39.0258 × 0.5800 − 40 . I .) × 0.4959 = 3.67 This means that when the stock price changes by a small
amount, the option price changes by about 60% of that amount.
FINA 4110 (Dr. Edwin Mok) Lecture 6 31 FINA 4110 (Dr. Edwin Mok) Lecture 6 32
 6.4b Delta 6.4b Delta
• Assume that an investor who has sold 20 call option contracts would like to buy • The investor’s position could be hedged if he makes $ MOJKP QK R= S=TQ= = $0.
shares to hedge. • $0 = −$ MOJKP QK MJTT R=<QUQ=K + $ MOJKP QK U= V R=<QUQ=K
C=$10 with ∆=0.6 C=$10 with ∆=0.6
Short 20 call option contracts Multiplier: 100 shares Short 20 call option contracts Multiplier: 100 shares

∆ = −0.6 × 20 × 100 = −1,200 ∆ = −0.6 × 20 × 100 = −1,200

Offset The gain (loss) on the stock position would tend to
The trader loses 1,200∆S on the option offset the loss (gain) on the option position.

S=$100 position when the stock price increases by ∆S. S=$100 Long 1,200 <OJ <
Stock The delta of one share of the stock is always 1.0. Stock The delta of one share of the stock is always 1.0.

FINA 4110 (Dr. Edwin Mok) Lecture 6 33 FINA 4110 (Dr. Edwin Mok) Lecture 6 34

6.4b Delta 6.4c Delta

• The investor’s position could be hedged if he makes $ MOJKP QK R= S=TQ= = $0. • It is important to realize that, since the delta of an option does not remain
• $0 = −$ MOJKP QK MJTT R=<QUQ=K + $ MOJKP QK U= V R=<QUQ=K constant, the trader’s position remains delta neutral for only a relatively short
period of time.
C=$10 with ∆=0.6
Short 20 call option contracts Multiplier: 100 shares
• The hedge has to be adjusted periodically. This is known as rebalancing.
Option Price ∆ S
The delta of the trader’s overall position is, therefore, zero.
A position with a delta of zero is referred to as delta neutral.
M
S=$100 Long 1,200 <OJ <
Stock The delta of one share of the stock is always 1.0.
Stock Price
FINA 4110 (Dr. Edwin Mok) Lecture 6 35 FINA 4110 (Dr. Edwin Mok) Lecture 6 36
 6.4c Delta 6.4c Delta
• What if, by the end of 1 day, the stock price increases to $110 and delta rises • A procedure that adjust the hedging position on a regular basis is called
to 0.65? dynamic hedging.
• It is contrasted with static hedging, where a hedge is set up initially and
C=$10 with ∆=0.65
never adjusted.
Short 20 call option contracts Multiplier: 100 shares • Static hedging is sometimes also referred to as ‘‘hedge-and-forget.’’
∆
∆ = −0.65 × 20 × 100 = −1,300
Offset
An extra 100 shares would then have to be purchased Sell shares No Trade
0.6
to maintain the hedge Buy shares
S=$110 Long 1,300 <OJ <
Stock The delta of one share of the stock is always 1.0. Buy shares
time
0
FINA 4110 (Dr. Edwin Mok) Lecture 6 37 FINA 4110 (Dr. Edwin Mok) Lecture 6 38

6.4d Delta 6.4d Delta

• Delta is closely related to the Black–Scholes–Merton analysis.

For a European call option on a non-dividend-paying stock, MJTT TUJ = ( ). For a European put option on a non-dividend-paying stock, RWU TUJ = − 1.

= − = −
Long 1,000 calls × 0.8 + Short 800 shares = ∆ = 0 Long 1,000 puts × (0.8 - 1) + Long 200 shares = ∆ = 0
Using delta hedging for a long position in a European call option involves Delta is negative, which means that a long position in a put option should be
maintaining a short position of ( ) shares for each option purchased. hedged with a long position in the underlying stock.

The delta of a short position in one call option is − ( ).

=> Long/Short 800 shares?

FINA 4110 (Dr. Edwin Mok) Lecture 6 39 FINA 4110 (Dr. Edwin Mok) Lecture 6 40
 Figure 19.3 Variation of delta with stock price for (a) a call option Figure 19.3 Variation of delta with stock price for (a) a call option
and (b) a put option on a non-dividend-paying stock. and (b) a put option on a non-dividend-paying stock.
Option Delta Option Delta
Price of Call Price of Put
Stock
1.0 0
Price
0.9 -0.1

0.5 -0.5

Stock 0.1 Stock -0.9

Stock
Price Price -1.0
Price

FINA 4110 (Dr. Edwin Mok) Lecture 6 41 FINA 4110 (Dr. Edwin Mok) Lecture 6 42

Q3. Delta 6.4e Delta

Assume that the stock price is $49, the strike price is $50, the risk-free rate is 5%, • The operation of delta hedging for a call writer.
the time to maturity is 5 weeks, and the volatility is 20%. What is the call delta?
• Assume that the stock price is $49, the strike price is $50, the risk-free rate is
$% !.%% X
! /" # #% 'I/) # . )# % ×X% 5%, the time to maturity is 5 weeks, and the volatility is 20%.
•d = = = −0.2172
& X
. X%
• 10,000 call options are sold at $0.8789 each and the hedge is assumed to be
adjusted weekly.
• = −0.2172 = 0.414
Hedging Costs?
• When the stock price changes by ∆S, the option price changes by 0.414∆S. +$8,789

Time
0 T
FINA 4110 (Dr. Edwin Mok) Lecture 6 43 FINA 4110 (Dr. Edwin Mok) Lecture 6 44
 The 1st simulation of delta hedging. Table 1 The 1st simulation of delta hedging.
• The first simulation of delta hedging. At the end of the first week:
At the beginning of the first week: The initial value of delta for a single option is 0.414. An interest cost of $202,867 × 5% × = $195 is therefore incurred.
)
Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative
price shares for shares traded from trading Cost Borrowings price shares for shares traded from trading Cost Borrowings
hedging hedging

0 49.00 -0.217 0.4140 4,140 4,140 -202,860 0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055

$202,867 must be borrowed to buy 4,140

This means that the delta of the option shares at $49 to create a delta-neutral position.
The cumulative borrowings is 202,860 + 195 = $203,055.
position is initially −0.414 × 10,000 = −4,140.
FINA 4110 (Dr. Edwin Mok) Lecture 6 45 FINA 4110 (Dr. Edwin Mok) Lecture 6 46

Table 1 The 1st simulation of delta hedging. Table 1 The 1st simulation of delta hedging.
At the beginning of the second week: At the end of the second week:
The stock price drops to $48.5, and the delta of the option drops to 0.3256. The interest costs is 203,055 − 42,874 × 5% × = 154
)
Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative
price shares for shares traded from trading Cost Borrowings price shares for shares traded from trading Cost Borrowings
hedging hedging

0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055 0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055
1 48.50 -0.452 0.3256 3,256 -884 42,874 1 48.50 -0.452 0.3256 3,256 -884 42,874 154 160,335

884 of the shares initially purchased are

sold to maintain the delta-neutral hedge.

The new delta of the option position is The strategy realizes 48.5 × 884 =
$42,874 in cash. The cumulative borrowings are reduced to 203,055 − 42,874 + 154 = $160,355.
− 0.3256 × 10,000 = −3,256.
FINA 4110 (Dr. Edwin Mok) Lecture 6 47 FINA 4110 (Dr. Edwin Mok) Lecture 6 48
Table 1 The 1st simulation of delta hedging. Table 1 The 1st simulation of delta hedging.
Profit with hedging: $8,789 − $5,700 + $89,913 − $95,547 = −$2,545 Profit with hedging: $8,789 − $5,700 + $89,913 − $95,547 = −$2,545
The investor receives 0.8789 × 10,000 = $8,789 from selling the call options.
Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative
price shares for shares traded from trading Cost Borrowings price shares for shares traded from trading Cost Borrowings
hedging hedging
Profit without hedging: $8,789 − $5,700 = $3,089 Profit without hedging: $8,789 − $5,700 = $3,089
0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055 0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055
1 48.50 -0.452 0.3256 3,256 -884 42,874 154 160,335 1 48.50 -0.452 0.3256 3,256 -884 42,874 154 160,335
2 49.78 -0.008 0.4969 4,969 1,713 -85,273 236 245,844 2 49.78 -0.008 0.4969 4,969 1,713 -85,273 236 245,844
3 50.91 0.528 0.7014 7,014 2,045 -104,111 336 350,292 3 50.91 0.528 0.7014 7,014 2,045 -104,111 336 350,292
4 48.67 -0.924 0.1778 1,778 -5,236 254,836 92 95,547 4 48.67 -0.924 0.1778 1,778 -5,236 254,836 92 95,547
5 50.57 The cumulative borrowings are $95,547. 5 50.57

As a call writer, the investor has to pay The investor receives 1,778 × Delta hedging a short position generally involves selling stock just after the
(50.57 − 50) × 10,000 = $5,700 to call holder. 50.57 = $89,913 for the stock held. price has gone down and buying stock just after the price has gone up.
FINA 4110 (Dr. Edwin Mok) Lecture 6 49 FINA 4110 (Dr. Edwin Mok) Lecture 6 50

Table 2 The 2nd simulation of delta hedging. Table 2 The 2nd simulation of delta hedging.
• The second simulation of delta hedging Profit with hedging: $8,789 − $5,700 + $423,979 − $419,554 = $7,513
The investor receives 0.8789 × 10,000 = $8,789 from selling the call options.
Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative
price shares for shares traded from trading Cost Borrowings price shares for shares traded from trading Cost Borrowings
hedging The cost of hedging increases hedging
with the stock price volatility. Profit without hedging: $8,789 − $5,700 = $3,089
0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055 0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055
1 49.72 -0.004 0.4983 4,983 843 -41,914 236 245,205 1 49.72 -0.004 0.4983 4,983 843 -41,914 236 245,205
2 50.11 0.130 0.5516 5,516 533 -26,709 261 272,175 2 50.11 0.130 0.5516 5,516 533 -26,709 261 272,175
3 50.98 0.564 0.7135 7,134 1,618 -82,486 341 355,001 3 50.98 0.564 0.7135 7,134 1,618 -82,486 341 355,001
4 51.32 0.988 0.8384 8,384 1,250 -64,150 403 419,554 4 51.32 0.988 0.8384 8,384 1,250 -64,150 403 419,554
5 50.57 5 50.57 The cumulative borrowings are $419,554.
As a call writer, the investor has to pay The investor receives 8,384 ×
The closing price after 5 weeks is coincidently the same as in the first simulation. (50.57 − 50) × 10,000 = $5,700 to call holder. 50.57 = $423,979 for the stock held.
Lecture 6
FINA 4110 (Dr. Edwin Mok) Lecture 6 51 FINA 4110 (Dr. Edwin Mok) 52
 Q4. Delta Hedging 6.4h Delta
Use the information in table 3 to find out the profit with hedging and profit without • If the hedging worked perfectly, the cost of hedging would, after discounting, be
hedging. exactly equal to the Black–Scholes–Merton price for every simulated stock price path.
Week Stock d1 N(d1) Number of Number of Cash flow Interest Cumulative
price shares for shares traded from trading Cost Borrowings
hedging • The costs of hedging the option, when discounted to the beginning of the period, are
0 49.00 -0.217 0.4140 4,140 4,140 -202,860 195 203,055 close to but not exactly the same as the Black–Scholes–Merton price.
1 49.73 -0.001 0.4997 4,997 857 -42,619 236 245,910
2 50.35 0.229 0.5906 5,906 909 -45,768 280 291,959
3 51.42 0.783 0.7830 7,830 1,924 -98,932 376 391,266 • The variation in the cost of hedging is that the hedge is rebalanced only once a week.
4 52.08 1.518 0.9355 9,355 1,525 -79,422 453 471,141
5 52.25 Is it profitable to sell options?
• Profit with hedging: $8,789 − $22,500 + $92,901 − $78,608 = $581
• Profit without hedging: $8,789 − $22,500 = −$13,711 Option Price Cost of Hedging
• With appropriate hedging, call writer can make profit in an upward market
periods.
FINA 4110 (Dr. Edwin Mok) Lecture 6 53 FINA 4110 (Dr. Edwin Mok) Lecture 6 54

6.4h Delta 6.4i Delta

• As rebalancing takes place more frequently, the variation in the cost of • The performance measure of a delta-hedging strategy is the ratio of the
hedging is reduced. standard deviation of the cost of writing the option and hedging it to the
theoretical price of the option. Simulations
• The cost of hedging would be higher when there are transaction costs and Rebalancing once per month
market frictions. Rebalancing once per week
Rebalancing twice per week Standard
Option Price
Deviation
Rebalancing once per month
Rebalancing once per week Cost of Hedging
Rebalancing twice per week Standard Deviation
Option Price Performance
Option Price

FINA 4110 (Dr. Edwin Mok) Lecture 6 55 FINA 4110 (Dr. Edwin Mok) Lecture 6 56
 6.4i Delta 6.4j Delta
• The performance of a delta-hedging strategy gets steadily better as the hedge • The delta of a portfolio (∆P) of options or other derivatives dependent on a single
is monitored more frequently. asset.

• If a portfolio consists of a quantity wi of option i (1 ≤ i ≤ n), ∆Z = ∑^]_ \] ∆]

Time between hedge 5 4 2 1 0.5 0.25 0.2 • The formula can be used to calculate the position in the underlying asset
rebalancing (weeks): necessary to make the delta of the portfolio zero.
Performance measure 0.42 0.38 0.28 0.21 0.16 0.13 Option A

Option B Delta of a Portfolio

……
Derivatives dealers usually rebalance their Delta
positions once a day to maintain delta neutrality. Neutral
Underlying asset

FINA 4110 (Dr. Edwin Mok) Lecture 6 57 FINA 4110 (Dr. Edwin Mok) Lecture 6 58

6.4j Delta 6.4j Delta

• Suppose a financial institution has the following three positions in options on a stock: • The delta of the whole portfolio is:
A long position in 100,000 calls with strike
price $55 and an expiration date in 3 months.
100,000 × 0.533 − 200,000 × 0.468 − 50,000 × −0.508
A short position in 200,000 calls with strike
price $56 and an expiration date in 5 months.
+100,000 Calls @ $55 ∆= 0.533 +100,000 Calls @ $55 ∆= −14,900
-200,000 Calls @ $56 Delta of a Portfolio ∆= 0.468 -200,000 Calls @ $56 Delta of a Portfolio
Delta
-50,000 Puts @ $56 ∆= −0.508 -50,000 Puts @ $56 Neutral
Underlying asset
A short position in 50,000 puts with strike This means that the portfolio can be made
price $56 and an expiration date in 2 months. delta neutral by buying 14,900 shares. `=KP 14,900 <OJ <
FINA 4110 (Dr. Edwin Mok) Lecture 6 59 FINA 4110 (Dr. Edwin Mok) Lecture 6 60
 Case: Delta 6.5a Theta
• The theta (Θ) of a portfolio of options is the
rate of change of the value of the portfolio S
with respect to the passage of time with all Delta
else remaining the same.
Theta
• Dividing Theta per trading day by the option
Option
price, you can estimate the opportunity cost
of holding the option for one trading cost in Price
percentage of the option price.
From Black Scholes Formula

Θ = −1.10 Trading days remaining = 10

-20%
Option Price = $0.55
FINA 4110 (Dr. Edwin Mok) Lecture 6 61 FINA 4110 (Dr. Edwin Mok) Lecture 6 62

6.5a Theta 6.5a Theta

• An exception to this could be an in-the-money European put option.
Theta is the cost of using options for speculation or for hedging purposes.
$
Max Gain = $50 Deep-in-the-money Put
As time passes with all else remaining the same,
the option tends to become less valuable. Intrinsic Value = $40

Theta is usually negative for an option.

Θ = −1.10 Trading days remaining = 10

-20%
Option Price = $0.55 ST
S0=$10 K=$50
FINA 4110 (Dr. Edwin Mok) Lecture 6 63 FINA 4110 (Dr. Edwin Mok) Lecture 6 64
 Figure 19.5 Variation of theta of a European call
option with stock price.
Case: Opportunity Cost of Holding Option
• For an European call option: For a at-the-money call option,
Theta theta is at its highest.

For far out of the money K Stock

option, theta is close to zero as Price
the call price is almost zero.

As the stock price becomes

larger, theta tends to be larger.

FINA 4110 (Dr. Edwin Mok) Lecture 6 65 FINA 4110 (Dr. Edwin Mok) Lecture 6 66

6.6a Gamma Figure 19.7 Hedging error introduced by nonlinearity.

• The gamma (Γ) of a portfolio of options on an Gamma
underlying asset is the rate of change of the S When the stock price moves from S to S0, delta hedging assumes that
portfolio’s delta with respect to the price of the Delta the option price moves from C to C’, when in fact it moves from C to C’’.
underlying asset. Call Price Actual Call Price
Theta
Gamma measures this curvature.
• If gamma is small, delta changes slowly, and Expected Call Price
Adjustment Option The difference between C’ and
adjustments to keep a portfolio delta neutral
need to be made only relatively infrequently. Frequency Daily Price C’’ leads to a hedging error.
C’’
• If gamma is large, delta is very sensitive to The size of the error depends on the
C’
the price of the underlying asset. Hedging curvature of the relationship between
• It is then quite risky to leave a delta-neutral Error the option price and the stock price.
Weekly Weekly C
portfolio unchanged for any length of time.
Gamma Stock Price
S S’
FINA 4110 (Dr. Edwin Mok) Lecture 6 67 FINA 4110 (Dr. Edwin Mok) Lecture 6 68
 6.6b Gamma 6.6b Gamma
• Making a portfolio gamma neutral as well as delta-neutral can be regarded as Suppose that a delta-neutral portfolio has a gamma equal to Γ.
a correction for the hedging error.
A traded option has a gamma equal to ΓT.
Call Price Actual Call Price The number of traded options added to the portfolio is wT.
Γ wT ΓT
Gamma neutrality provides protection against

C’’
large stock price between rebalancing. Expected Call Price
Delta-neutral
portfolio
Number of
Traded Option
Traded
Option 0
C’
Delta neutrality provides protection against Gamma
small stock price moves between rebalancing. The gamma of the portfolio is \ Γ + Γ. Neutral
C
The position in the traded option necessary to make
Stock Price the portfolio gamma neutral is \ =
c
.
S S’ c@
FINA 4110 (Dr. Edwin Mok) Lecture 6 69 FINA 4110 (Dr. Edwin Mok) Lecture 6 70

6.6b Gamma Case: IV Senstivity

Suppose that a portfolio is delta neutral and has a gamma of -3,000.
The gamma of a particular traded call option is 1.50.
The portfolio can be made gamma neutral by including in the
E,
portfolio a long position of = 2,000 in the call option.
.) Gamma
-3,000 2,000 1.50 Neutral
Delta-neutral
portfolio
Number of
Traded Option
Traded
Option 0
+1,240 2,000
1,240 units of the underlying asset must be
0.62 0
The delta the traded Delta
sold from the portfolio to keep it delta neutral. 1,240 call option is 0.62. Neutral
However, the delta of the portfolio will then
change from zero to 2,000 × 0.62 = 1,240.
FINA 4110 (Dr. Edwin Mok) Lecture 6 71 FINA 4110 (Dr. Edwin Mok) Lecture 6 72
 Figure 19.11 Variation of vega with stock price
6.7a Vega for an option.
• The vega (V) of a portfolio of derivatives, is the Gamma
rate of change of the value of the portfolio with S Vega
respect to the volatility of the underlying asset. Delta

Price Theta
The vega of a long position in a European
Option
or American option is always positive.
P1 Price
Vega
σ
P2
If vega is highly positive or highly
σ negative, the portfolio’s value is very Stock
sensitive to small changes in volatility. K Price
σ
A position in the underlying asset has zero vega.
FINA 4110 (Dr. Edwin Mok) Lecture 6 73 FINA 4110 (Dr. Edwin Mok) Lecture 6 74

6.7b Vega 6.7c Vega

• The vega of a portfolio can be changed, similarly to the way gamma can be Consider a portfolio that is delta neutral, with a gamma of -5,000 and a vega of -8,000.
changed, by adding a position in a traded option.
w1 and w2 are the quantities of Option 1 and Option 2,
Assume that V is the vega of the portfolio. VT is the vega of a traded option. \ \
Portfolio
Additional position Original portfolio Option 1 Option 2
Gamma Neutral

Delta 0 \ 0.6 \ 0.5

V wT VT
Gamma -5,000 \ 0.5 \ 0.8 0
Original
portfolio
Number of
Traded Option
Traded
Option
0 Vega -8,000 \ 2.0 \ 1.2 0
e
A position of \ = in the traded option makes the Gamma
e@ Portfolio
portfolio instantaneously vega neutral. Neutral Vega Neutral
FINA 4110 (Dr. Edwin Mok) Lecture 6 75 FINA 4110 (Dr. Edwin Mok) Lecture 6 76
 6.7c Vega 6.7c Vega
The portfolio can therefore be made by including 400 of Option 1 and 6,000 of Option 2.
Gamma -5,000 \ 0.5 \ 0.8 0 The delta of the portfolio increases by 400 × 0.6 + 6,000 × 0.5 = 3,240.
• −5,000 + 0.5\ + 0.8\ = 0
• 0.5\ = 5,000 − 0.8\ Portfolio Delta
• \ = 10,000 − 1.6\ Original
400 6,000 Neutral
portfolio Option 1 Option 2 Stock
Vega -8,000 \ 2.0 \ 1.2 0 Delta 0 \ 0.6 \ 0.5 -3,240 0
• −8,000 + 2.0\ + 1.2\ = 0
• −8,000 + 2.0(10,000 − 1.6\ ) + 1.2\ = 0 Gamma -5,000 \ 0.5 \ 0.8 0 0
• 12,000 − 2.0\ = 0 \ 1.2
• \ = 6,000 The solution to these equations is Vega -8,000 \ 2.0 0 0
\ = 400 JK \ = 6,000.
• \ = 10,000 − 1.6\ Hence, 3,240 units of the asset would Portfolio Portfolio
• \ = 10,000 − 1.6 6,000 = 400 have to be sold to maintain delta neutrality. Vega Neutral Gamma Neutral
FINA 4110 (Dr. Edwin Mok) Lecture 6 77 FINA 4110 (Dr. Edwin Mok) Lecture 6 78

6.8a Rho 6.9a Realities of Hedging

• The rho (ρ) of a portfolio of options is the rate Gamma • In a typical arrangement at a financial institution, the responsibility for a
of change of the value of the portfolio with S portfolio of derivatives dependent on a particular underlying asset is assigned
respect to the interest rate. Delta to one trader or to a group of traders. Limits are defined for each Greek
letter and special permission is
Theta required if a trader wants to exceed
Team A a limit at the end of a trading day.
Option
Vega Price Θ V
σ
Rho
Team B
∆ Γ ρ

……
……
Options traders make themselves close to delta neutral at the end of each day.
FINA 4110 (Dr. Edwin Mok) Lecture 6 79 FINA 4110 (Dr. Edwin Mok) Lecture 6 80
 6.9a Realities of Hedging 6.9b Realities of Hedging
• The delta limit is often expressed as the equivalent maximum position in the • Whether it is best to use an available traded option for vega or gamma hedging
underlying asset. depends on the investor expectation, risk tolerance, and transaction costs.

If the stock price is $50, this

20,000 shares@$50 means that the absolute value of
Team A delta as we have calculated it
can be no more than 20,000. Hedging
Team B
∆ $1,000,000
ΓV
……
……

For example, the delta limit of Goldman Sachs for a stock might be $1 million.
FINA 4110 (Dr. Edwin Mok) Lecture 6 81 FINA 4110 (Dr. Edwin Mok) Lecture 6 82

OFOD Table 19.5 Profit or loss realized in 2 weeks

6.9c Realities of Hedging under different scenarios ($ million)
• In addition to monitoring greeks, option traders often also carry out a scenario • Consider a bank with a portfolio of options on a foreign currency. Long Calls
analysis. • The value of the portfolio depends on the exchange rate and the
exchange-rate volatility. Short Calls
• The analysis involves calculating the gain or loss on their portfolio over a • The bank could conduct a scenario analysis showing the profit or
Long Puts
specified period under a variety of different scenarios. loss experienced during a 2-week period by considering seven
different exchange rates and three different volatilities. Short Puts
One dimension
∆ ΘΓV ρ
Best case Scenario Seven exchange rates scenarios Base case Scenario
Volatility Exchange rate Worst
0.94 0.96 0.98 1.00 1.02 1.04 1.06 case
Three 8% +102 +55 +25 +6 -10 -34 -80 Scenario
volatilities 10% +80 +40 +17 +2 -14 -38 -85
scenarios 12% +60 +25 +9 -2 -18 -42 -90
σ Usually the greatest loss in a table occurs at one of the corners.
FINA 4110 (Dr. Edwin Mok) Lecture 6 83 FINA 4110 (Dr. Edwin Mok) Lecture 6 84
 Table 4 Formulas for European options on an OFOD Table 19.6 Formulas for European options on
asset that has zero dividend yield. an asset that provides a dividend yield at rate q.
Variables Call option Put option Variables Call option Put option
Price • = j − • = − − j −
Price • = − • = − − −
Delta • ∆= j ( ) • ∆= j [ − 1]
Delta • ∆= ( ) • ∆= −1
d1 and –d1 $% $%
d1 and –d1 $% $% ! /" # j# % ! /" # j# %
! /" # #% ! /" # #%
• d = • −d = −
• d = • −d = − & &
& &

d2 and –d2 $% $%
d2 and –d2 $% $% ! /" # j % ! /" # j %
! /" # % ! /" # % • d = • −d = −
• d = • −d = − & &
& &

N’(x) • f g = i%/
N’(x) • f g = i%/ h
h

FINA 4110 (Dr. Edwin Mok) Lecture 6 85 FINA 4110 (Dr. Edwin Mok) Lecture 6 86

OFOD Chapter 15 Q32. OFOD Chapter 15 Q32.

Consider a call option when the stock price is $18, the exercise price is $20, the
$% !.F%
time to maturity is six months, the volatility is 30% per annum, and the risk-free ! /" # #% G. I/ # . # % × .)
interest rate is 10% per annum. Two equal dividends are expected during the life •d = = = −0.3629
& .E .)
of the option, with ex-dividend dates at the end of two months and five months.
Assume the dividends are 40 cents. What is the value of the option if it is G. I/ # .
!.F%
× .)
%
European style? •d = = −0.5751
.E .)

• = 20, = 0.1, = 0.3, JK = 0.5 • = −0.3629 = 0.3583 & = −0.5751 = 0.2826

% X
. × 2% . × 2%
• Rm(n) = 0.4 + 0.4 = 0.7771 • = − = 17.2229 × 0.3583 − 20 . .) × 0.2826 = 0.7947

• A pW<U = − Rm n = 18 − 0.7771 = 17.2229

FINA 4110 (Dr. Edwin Mok) Lecture 6 87 FINA 4110 (Dr. Edwin Mok) Lecture 6 88
 OFOD Chapter 19 Q24. OFOD Chapter 19 Q24.
a. What position in the traded option and in sterling would make the portfolio both
gamma neutral and delta neutral?
• A financial institution has the following portfolio of over-the-counter options on sterling:
Type Position Delta of Option Gamma of Option Vega of Option
Type Position Delta of Gamma of Vega of Option Call −1,000 0.5 2.2 1.8
Option Option Call −500 0.8 0.6 0.2
Call −1,000 0.5 2.2 1.8 Put −2,000 -0.40 1.3 0.7
Call −500 0.8 0.6 0.2 Call −500 0.70 1.8 1.4
Put −2,000 -0.40 1.3 0.7 Portfolio -450 -6,000 -4,000
Call −500 0.70 1.8 1.4
O n TUJ =S UO = US=TQ= = −1,000 × 0.5 − 500 × 0.8 − 2,000 × −0.4 − 500 × 0.7
• A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
O qJrrJ =S UO = US=TQ= = −1,000 × 2.2 − 500 × 0.6 − 2,000 × 1.3 − 500 × 1.8

O m PJ =S UO = US=TQ= = −1,000 × 1.8 − 500 × 0.2 − 2,000 × 0.7 − 500 × 1.4

FINA 4110 (Dr. Edwin Mok) Lecture 6 89 FINA 4110 (Dr. Edwin Mok) Lecture 6 90

OFOD Chapter 19 Q24. OFOD Chapter 19 Q24.

A long position in 4,000 traded options will give a gamma−neutral b. What position in the traded option and in sterling would make the portfolio both
portfolio since the long position has a gamma of 4,000 × 1.5 = +6,000. vega neutral and delta neutral?
Type Position Delta of Option Gamma of Option Vega of Option
Type Position Delta of Option Gamma of Option Vega of Option
Call −1,000 0.5 2.2 1.8
Call −1,000 0.5 2.2 1.8
Call −500 0.8 0.6 0.2
Call −500 0.8 0.6 0.2
Put −2,000 -0.40 1.3 0.7
Put −2,000 -0.40 1.3 0.7
Call −500 0.70 1.8 1.4
Call −500 0.70 1.8 1.4 Portfolio -450 -6,000 -4,000
Portfolio -450 -6,000 -4,000 Long 5,000 Options +3,000 +4,000
Long 4,000 Options +2,400 +6,000 Short 2,550 Shares -2,550
-1,950 A long position in 5,000 traded options will give a vega−neutral portfolio
Short 1,950 Shares
since the long position has a vega of 5,000 × 0.8 = +4,000.
The delta of the whole portfolio is then: 4,000 × 0.6 − 450 = 1,950. The delta of the whole portfolio is then: 5,000 × 0.6 − 450 = 2,550.
Hence, in addition to the 4,000 traded options, a short position of 1,950 in Hence, in addition to the 5,000 traded options, a short position of 2,550 in
sterling is necessary so that the portfolio is both gamma and delta neutral. sterling is necessary so that the portfolio is both vega and delta neutral.
FINA 4110 (Dr. Edwin Mok) Lecture 6 91 FINA 4110 (Dr. Edwin Mok) Lecture 6 92
 OFOD Chapter 19 Q27. OFOD Chapter 19 Q27.
• A deposit instrument offered by a bank guarantees that investors will receive a • The product provides a six-month return equal to Bst(0, 0.4u).
return during a six-month period that is the greater of (a) zero and (b) 40% of • where R is the return on the index.
the return provided by a market index. An investor is planning to put $100,000
in the instrument. Describe the payoff as an option on the index. Assuming
that the risk-free rate of interest is 8% per annum, the dividend yield on the • Suppose that S0 is the current value of the index and ST is the value in six
index is 3% per annum, and the volatility of the index is 25% per annum, is the months.
product a good deal for the investor?
T=0 T = 0.5
In-the-money • When an amount A is invested, the return received at the end of six months is:
Upside Potential • = s × BJg 0,0.4 × @ !

Bank Charges Interest Income .'v

!

Call Options Interest •= × BJg 0, −

Guaranteed !
Deposit .'v
Bond Principal Amounts • This is of at-the-money European call options on the index.
!

FINA 4110 (Dr. Edwin Mok) Lecture 6 93 FINA 4110 (Dr. Edwin Mok) Lecture 6 94

OFOD Chapter 19 Q27. OFOD Chapter 19 Q27.

• With the usual notation, the product has a valuation: If an investor buys the product he or The cash flows to the investor are therefore
.'v • Time 0: −s + 0.0325s = −0.9675s
• m= × − she avoids having to pay 0.0325A at
!
time zero for the underlying option. • After six months: +s

• As K = S for at-the-money option, m = 0.4s × j − The product is therefore slightly less

attractive than a risk-free investment (8%).
w! $% !.%X%
# j# % # . L . E# % × .)
•d =
x
= = 0.2298, = 0.5909 T=0 Bank Charges T = 0.5
& . ) .)
Upside Potential
•d = − = 0.2298 − 0.25 0.5 = 0.0530, = 0.5212 0.0325A
6.6%
A The return with continuous A
• m = 0.4s × . E× .)
× 0.5909 − . L× .)
× 0.5212 = 0.0325s 0.9675A compounding is 2 ×Principal
• This is the present value of the payoff from the product. TK = 6.6% JKKWr.
.IDG)
FINA 4110 (Dr. Edwin Mok) Lecture 6 95 FINA 4110 (Dr. Edwin Mok) Lecture 6 96
 OFOD Appendix:
OFOD Chapter 19 Q27. Table for N(x) When x ≤ 0
• The table should be used with
interpolation. For example,
• −0.1234 = −0.12 −
. E' .
[ −0.12 − (−0.13)]
. E .
• −0.1234 = 0.4522 − 0.34(0.4522 −
0.4483) = 0.4509
T=0 T = 0.5
Upside Potential
0.0325A
0.0067A D
. L( )
A s A
0.9608A

FINA 4110 (Dr. Edwin Mok) Lecture 6 97 FINA 4110 (Dr. Edwin Mok) Lecture 6 98

OFOD Appendix:
Table for N(x) When x ≥ 0
• The table should be used with interpolation.
For example,
• 0.6278 = 0.62 +
.D GL .D
[ 0.63 − (0.62)]
.DE .D
• 0.6278 = 0.7324 + 0.78(0.7357 −
0.7324) = 0.7350

FINA 4110 (Dr. Edwin Mok) Lecture 6 99