Hull RMFI4 e CH 07

Valuation and Scenario
Analysis: The Risk-

Neutral and Real Worlds
Chapter 7
Risk Management and Financial Institutions 4e, Chapter 7, Copyright © John C. Hull 2015 1
Valuation vs. Scenario Analysis
 In valuation, we are interested in the
present value of future cash flows
 In scenario analysis, we are interested in
the range of situations that might exist at a
future time
Example (page 137)
 One-year European call option on a stock
worthy $50 with a strike price of $55
 The value might be calculated as $4.5 and
it might be sold for $5
 But a scenario analysis might show there
is a 5% chance of the stock price rising
above $80
 This would cost the seller about $20
Volatility and Asset Prices
 If the average return from an asset is 
and its volatility is  then the most popular
model (known as geometric Brownian)
motion gives

ln ST   ln S 0  (   2 2)T ,  2T 
where ST is the stock price at time T and
(m,v) is a normal distribution with mean m
and variance v.
Probability of Extreme Values
Prob( ST  V )  N (d 2 )
Prob( ST  V )  N (d 2 )
where
ln(S 0 V )  (   2 2)T
d2 
 T
and N ( x) is the probability that a variable with a standard normal
distribution will be less than x

Prob( ST  V )  q when V  S 0 exp (   2 2)T  N 1 (q ) T 
Prob( ST  V )  q when V  S exp(  
0
2
2)T  N 1 (q ) T
Risk-Neutral Valuation (pages 139-143)
 In a risk-neutral world investors do not
require an extra expected return for
bearing risks
 If when valuing derivatives we assume
that the world is risk-neutral, we get the
right valuation for the real world (where
investors do require an extra return for
bearing risks) as well as for the risk-
neutral world
Options, Futures, and Other Derivatives, 9th Edition, Copyright © John C. Hull 2014 6
Applying Risk-Neutral Valuation to
Value a European Stock Option
1. Assume that the expected

return from the stock is the
risk-free rate
2. Calculate the expected payoff
from the option
3. Discount at the risk-free rate
Valuing a Forward Contract with
Risk-Neutral Valuation
 Payoff is ST – K
 Expected payoff in a risk-neutral
world is S0erT – K
 Present value of expected payoff is
e−rT[S0erT – K] = S0 – Ke−rT
Valuing a Binary Option with
Risk-Neutral Valuation
 Consider a binary option that pays off $100 if the
stock price at time T is greater than V
 The value of the binary option is 100e−rTN(d2)
where r is the risk-free rate (assumed constant)
and N(d2) is the probability that the stock price is
greater than V in a risk-neutral world
ln( S 0 V )  (r   2 2)T
d2 
 T
Black-Scholes-Merton
c  e  rT Eˆ maxST  K , 0 
p  e  rT Eˆ maxK  S , 0  T
where c is the value of a European call

option, p is the value of a European put
option, K is the strike price and Ê denotes
expected value in a risk-neutral world
Discrete Future Outcomes (pages 142-
143)
 Suppose that a variable can take n different

values
 Define i as the value of a derivative that pays
off $1 if the ith outcome occurs
 When applying risk-neutral valuation we set the
risk-neutral probability of the ith outcome equal
to  i
n

j 1
j
Default Probabilities
 Risk-neutral default probabilities can be
implied from bond prices or credit spreads.
 They are greater than real-world default
probabilities
Girsanov’s Theorem (page 144)
 For valuation we work in the risk-neutral
world
 For scenario analysis we work in the real
world
 Girsanov’s theorem shows that when we
move from one world to the other
expected returns change but volatilities
stay the same
Why Both the Real and Risk-
Neutral Worlds Can Be Relevant
for Scenario Analysis
 In a scenario analysis we should
 Randomly sample paths followed by market
variables out to the time horizon
 Value the portfolio using risk-neutral valuation
at the time horizon for each sample
Monte Carlo Simulation (page 145)
 For a variable with a constant expected return,
, and a constant volatility, 
 
ln St  t  ln St     2 2 t   t
where  is a random sample from a standard
normal distribution
 This means

St  t  St exp    2 2 t   t 
Mean Reversion
 Interest rate, volatilities, and some
commodity prices follow mean reverting
processes where they are pulled back to a
long run average value
 Superimposed on the pull is a random
change
Determining Real World Processes
 To determine real world processes from risk-neutral
processes for a variable we can use CAPM to adjust the
expected return
 If  is the volatility of the variable, M is the volatility of an
index of market returns market,  is the correlation
between percentage changes in the variable and
percentage changes in the market index, then we should
increase the expected return by  where

  Excess of market return over risk - free rate
M
Example
 If a commodity is uncorrelated with the
return on a market index its expected
return should be the same in both worlds
 But if  = 0.3, = 40%, = 20%, and the
excess return of the market over the risk-
free rate is 6%, then =0.09 and the
expected return should be 3.6% higher in
the real world than the risk-neutral world

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Valuation and Scenario

Analysis: The Risk-

1. Assume that the expected

where c is the value of a European call

 Suppose that a variable can take n different

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