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    Irene P
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    Derivatives can be used to hedge risk by limiting exposure, but also enable speculation by taking on added risk for potential gain. Basic option pricing is based on the idea of a riskless hedge through an insurance-like scenario. By taking into account the current and future stock prices and volatility, the price of a derivative can be derived through simulation. While log-normal distributions are commonly used, they do not fully capture features like jumps and fat tails seen in empirical data.

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    Derivatives can be used to hedge risk by limiting exposure, but also enable speculation by taking on added risk for potential gain. Basic option pricing is based on the idea of a riskless hedge through an insurance-like scenario. By taking into account the current and future stock prices and volatility, the price of a derivative can be derived through simulation. While log-normal distributions are commonly used, they do not fully capture features like jumps and fat tails seen in empirical data.

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    17 views13 pages

    Derivatives & Risk Management

    Uploaded by

    Irene P
    Derivatives can be used to hedge risk by limiting exposure, but also enable speculation by taking on added risk for potential gain. Basic option pricing is based on the idea of a riskless hedge through an insurance-like scenario. By taking into account the current and future stock prices and volatility, the price of a derivative can be derived through simulation. While log-normal distributions are commonly used, they do not fully capture features like jumps and fat tails seen in empirical data.

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    of 13

    Derivatives & Risk Management

    Derivatives are mostly used to hedge (limit) risk

    But like most financial instruments, they can also be used for speculation taking on added risk in the expectation of gain

    Stodder: Derivatives, July

    Basics of Option Pricing


    Basic to Option Pricing is the idea of a Riskless Hedge A Riskless Hedge would be a situation in which you can buy some form of insurance that guarantees you the same money --whether the market goes up or down.

    Stodder: Derivatives, July

    Example of Riskless Hedge:


    Stock = $40, Call Option Buys it at $35
    Ending Stock Price $30 $50 Difference: $20
    Ending Stock Value $30 x 0.75 = $22.50 $50 x 0.75 = $37.50 Difference: $15

    minus Strike Price - $35 - $35 $0


    minus Strike Price - $35 - $35 $0

    = Option Value = $0 = $15 $15


    = Option Value $0 $15 $15

    (No one will buy)

    (No one will buy)

    Ending Stock Value $30 x 0.75 = $22.50 $50 x 0.75 = $37.50

    minus Option Value = Value of Porftolio $0 $22.50 $15 $22.50

    Stodder: Derivatives, July

    What is this Call Option Worth?


    Since this hedge is riskless, it should be evaluated at the risk-free rate. Say risk-free rate (on US Bonds) is 8%.

    In one year, Portfolio of $22.50 has Present Value of

    PV = $22.50/1.08 = $20.83

    Stodder: Derivatives, July

    Recall, Stock is now worth $40.


    So, it costs 0.75($40) = $30.00 to purchase

    of a share. Then
    Price of Option = Cost Stock PV Portfolio
    Price of Option = $30 $20.83

    = $9.17
    Stodder: Derivatives, July

    We have just derived the price


    We take as known the present and future prices of the underlying asset. We know the probabilities of these future prices. From this knowledge of future prices and probabilities, we derive the price of the derivative.

    Stodder: Derivatives, July

    In the simulation to follow, we will Go in Both Directions


    We will use knowledge of future prices and volatility on underlying asset to derive the current price of the option. We can also use knowledge of the current price to derive future prices and volatility.

    Stodder: Derivatives, July

    Run Simulation
    From Financial Models Using Simulation and Optimization by Wayne Winston.

    Stodder: Derivatives, July

    Limitations of Log-Normal Assumption


    Log-Normality fails to reproduce some of the important features of empirical asset price dynamics such as Jumps in the asset price Fat Tails of the Probability Distribution Function
    Empirical pdf

    St
    S0 Jump Fat Tails 0 T si 1 si Gaussian

    Stodder: Derivatives, July

    How is this Modeled?


    Mertons (1976) Jump Diffusion Process
    Size of Jumps is itself Log-Normally Distributed and added to the model. Timing of Jumps is Poisson Distributed.

    - Yusaku Yamamoto: Application of the Fast Gauss Transform to


    Option Pricing
    www.na.cse.nagoya-u.ac.jp/~yamamoto/work/KRIMS2004.ppt

    Stodder: Derivatives, July

    Derivatives get a Bad Name


    Most Financial Scandals of the last decade in the US and UK were linked to derivatives, some combination of excessive speculation and fraud:

    Barrings Bank Enron World-Com Back-Dating of Options


    Stodder: Derivatives, July

    Reasons for Fraud


    Leveraging makes possible fantastic gain, but also horrible losses Gamblers Last Desperate Hope (Adverse Selection) Complexity of Derivatives make fraud harder to identify

    Stodder: Derivatives, July

    Greater Long-Term Concern than Fraud: Systemic Risk


    The Moral Hazard of Insurance

    If you had a car that is less damaged by any given car crash would that make you drive faster? If you (and everybody else) drove faster, could this actually wind up making you less safe ?

    Stodder: Derivatives, July

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