Financial Derivatives

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 7 – Relative Value Trading

Arbitrage & Risk Neutral Valuation
 Option Pricing Theory allows us to compute the
Fair Value† of an asset.

 This lecture examines how we can expolit

differences between the fair value and the market
price to generate a riskless profit

†
Definition : Fair Value is the theoretically correct relative
value of the call option such that options traders cannot
generate a riskless profit by selling (if “overpriced”) or
buying (if “underpriced”) the Call and then “covering”
their risk exposures by trading the underlying asset
(augmented by borrowing / lending).
Arbitrage & Risk Neutral Valuation
 Lecture Objectives

 We will identify and exploit arbitrage

opportunities

 We will cover the theoritical basis of risk-neutral

valuation

 Both of these methods are used to correctly price

derivative securities, where the market price
differs from the fair-value price, a potential
arbitrage opportunity exists
Arbitrage
 Firstly some preliminary comment on the
Principles Behind Riskless Portfolio construction
Cτ

Cτ
S-X

Ct • ∆ Ct
∆ St
Sτ
St
∂Ct
∆≈ > 0but < 1
∂St
 We know that as the stock price moves ↑ ,the call
price moves ↑.This can be represented by the
option delta.
Arbitrage
 In effect, the call price does not move one-for-
one with the underlyiing equity price
 Now, assume you hold a long position in the Call
option (I.e. +Ct)
 Construct a portfolio with this Ct position and a
“certain amount” of shares such that that
portfolio remains riskless at all times.
 I.e., any unexpected small change in the call
price (ΔCt) will be exactly offset by the
corresponding change in the share holding
Arbitrage
 If we hold Δ many shares in the opposite
direction to the call position, we will be hedged
and the portfolio will be riskless

 I.e. if we hold –Δ.St shares (minus denotes a

short position) against one long call option.
Arbitrage
 Long Put Positions

 We know that as the stock price moves ↑ ,the put

price moves ↓.
 Therefore, we need a long position (+Δ.St) shares
to offset the change in the put price.
Arbitrage
 Data: S0 = 20, X=21, T=3 months, rF = 12% p.a.
SUT = 22 ⇒ CUT = 1

S0 = 20

SDT = 18 ⇒ CDT = 0

 Value the Call Option C0 by constructing a riskless

portfolio
 Use a short position in the call security and a long
position of Δ shares in the underlying equity
Arbitrage
 Now consider the possible Cash Flow (CF)
outcomes at t = T (option expiry/maturity)

CFs at T=0.25yrs Portfolio Value

UP +22.Δ - 1
DOWN +18.Δ - 0

 N.B. Short Call Payoff at maturity =

-Max(St-X, 0)
 Financial Engineering sign convention
 + for Long Positions
 - for short Positions
Arbitrage
 If our riskless portfolio is truly riskless, then in
either state (up or down), the value of the
portfolio is the same.
 Solve the equation:
+22.Δ – 1 = +18.Δ – 0
=> Δ = 0.25
 Therefore
PFUT = 22(0.25) – 1 = +4.5
PFDT = 18(0.25) – 0 = +4.5
Arbitrage
 The value of the future (t=T) portfolio today =
PFt=0 = e-R F.T .PFt=T
= e-0.12.0.25 .4.5
= 4.367

 But
PFt=0 = S0.Δ – C0
=> 4.367 = 20x0.25 – C0
=> C0 = 0.633

 C0 = 0.633 represents the fair value of the

option
Arbitrage
 There are two types of Arbitrage

 Type 1
 A riskless investment for which the rate of
return r > rF

 Type 2
 No initial investment, guaranteed positive
payoff at expiry
 A free-lunch
Arbitrage
 Arbitrage Type 1 Example
 Assume that the call option encountered
previously was trading at 0.70 rather than 0.633
 Step 1: Identify the Mispricing
 Call is overpriced by €0.067
 Step 2: Implement appropriate Arbitrage
Strategy and Hedge any Risk Exposure
 Sell Call
 Buy ∆ many share of underlying equity – i.e. a riskless
portfolio by construction !
 Step 3: Liquidate portfolio on option expiry and
see what % return is implied by this strategy.
Arbitrage
 Initial Outlay (Cash Flow)
At t = 0 CF
Sell 1 Call @ 0.7 = 0.7
Buy 0.25 shares @ 20 = -5.0
Total = -4.30

 And recall
CFs at T=0.25yrs Portfolio Value
UP +22x0.25 – 1 = 4.50
DOWN +18x0.25 – 0 = 4.50
Arbitrage
 So at t=0, we spent 4.30 to own the portfolio
 At t=T, we unwind (sell the call and buy the stock
back) to realise 4.50
 This gives us a net profit of 0.20
 The net return on this strategy is given by
− r ( 0.25 )
4.3 = 4.5e
 Taking the natural log of both sides
ln(4.3) = −0.25.r. ln(4.5)
⇒ ln = 18.185%
 I.e. r > rF!
Arbitrage
 With r > rF, contradicting the CAPM risk-return
trade-off formula!

 Given the opportunity described above, many in

the market will sell the calls and buy shares
 This activity will drive the option price towards
the fair-value, I.e. 6.33
 In an efficient market, this returning to
equilibrium will happen quickly

 Exercise, what is the implied rate of return on our

strategy if the option is priced at 6.333?
Arbitrage
 Arbitrage Type 2 Example

 Lets assume that the call option encountered

previously was trading at 0.60 rather than 0.633
 Step 1: Identify the Mispricing
 Call is underpriced by €0.033
 Step 2: Implement appropriate Arbitrage
Strategy and Hedge any Risk Exposure
 Buy Call (since it is underpriced)
 Sell ∆ many share of underlying equity (you will need to
borrow these first to sell them).
Arbitrage
 Step 3: Loan out the surplus cash (invest in
riskless government bonds) and receive rF
 Step 4: Liquidate portfolio on option expiry and
see what % return is implied by this strategy.

 Note that this strategy does not involve an initial

outlay of cash.
Arbitrage
 Initial Outlay (Cash Flow)
At t = 0 CF
Buy 1 Call @ 0.6 = -0.6
Sell 0.25 shares @ 20 = +5.0
Sub-Total = +4.40
Lend 4.4 at rF
Net-Total = zero outlay
Arbitrage
 At t=T (Cash Flow at Maturity)
At t = 0 CF
PFUT or PFDT = -4.5
Loan Recuperate = +4.534
Total = +0.034

 I.e. We have made a riskless profit without

spending any money

 Exercise, what is the implied rate of return on our

strategy if the option is priced at 6.333?
Risk Neutral Valuation
 Consider again
SUT = 22 ⇒ CUT = 1

S0 = 20

SDT = 18 ⇒ CDT = 0

 Previously, we used the no-arbitrage approach to

value the option.
 We will now value the option by calculating the
expected payoff at expiry and discount this back
to today.
Risk Neutral Valuation
 Previously, we used the no-arbitrage approach to
value the option.
 Construct a riskless portfolio in which you hold
the Call security short
 Therefore ∆ many of the underlying shares in an
offsetting long position.
 Remember, we don’t know what ∆ is!
 Let u denote the multiplicative UP factor and
d=1/u the DOWN factor – see binomial stock
price tree.
Risk Neutral Valuation
+ SUT = (S0.u).∆
- CUT ≡ - CU = - Max[SUT –X ]
S0.∆ - C0
+ SDT = (S0.d).∆
- CDT ≡ - CD = - Max[SDT –X ]

 Since the portfolio is riskless, we have

S 0u.∆ − C U = S 0 d .∆ − C D
( )
⇒ ∆ = C U − C D / ( S 0u − S 0 d ) …… (i)
Risk Neutral Valuation
 Initally, the portfolio set up cost was:
S 0 ∆ − C0
 This must be equal to the discounted payoff at
maturity (at either PFU or PFD state)
S 0 ∆ − C0 = ( S 0u.∆ − C U )e − RF T

( )
⇒ C0 = S 0 ∆ − S 0u.∆ − C U e − RF T

 Substituting in ∆ from equation (i)

⇒ C0 = e − RF T ( p.C U + (1 − p ) C D )

 where (
p = e RF T − d ) (u − d )
Risk Neutral Valuation
Note : u and d must imply
 Consider again: the same but opposite sign
SUT proportional change in price
p – i.e. returns +/- 10%
E0[ST] = ?

1-p
SDT

 where (
p = e RF T − d ) (u − d )
 Let u = 1.10, d = 0.90, rF = 12%, T = 0.25
 We can calculate p = 0.6523
Risk Neutral Valuation
 Interpreting p and (1-p) as probabilities, we can
calculate the expected future stock price
ET[ST] = SU.p + SD.(1-p)
= 20x1.1x0.6523 + 20x0.9x(1-0.6523)
= 20.61

 BUT note that the expected future stock price:

ET[S0] = S0.erFT = 20.e0.12(0.25) = 20.61

 In a risk-neutral world, we expect the stock

price to grow at the risk free rate
Risk Neutral Valuation
 This means that the probabilities we have used p
and (1-p) are the risk-neutral probabilities

 Confirm this by using them to prove that

expectations using them can be discounted to the
resent value of the asset, I.e.

S0 = e-r FT[SU.p + SD.(1-p)] = 20

Risk Neutral Valuation
 Using the Risk-Neutral Probabilities, we can
calculate the present value of the Call Option;
C0 = e-r FT[CU.p + CD.(1-p)]
C0 = e-0.12(0.25) [1x0.6523 + 0x(1-0.6523)]
= 0.633

 Now we have revalued the call option using the

Risk Neutral Valuation
Risk Neutral Valuation
 Reason we were able to use RN valuation is
because we were able to construct a truly riskless
PF comprising the Call and Equity securities.
 The risk-exposure facing the Call holder is
unanticipated changes in the underlying equity
price which can induce adverse changes in the
market value Call security.
 If this risk can be hedged by constructing a
riskless portfolio then we can equivalently value
the Call security using either No-Arbitrage (or
relative-value) valuation approach or the
equivalent RN methodology.
Risk Neutral Binomial Trees
 In practice, we do not know what u and d are but
we can estimate their values as a function of time
and volatility
u = eσ δt
d = e −σ δt
 See Hull page 249 for further information

 Further, recall that:

(
p = e − RF T − d ) (u − d )
 Risk Neutral Binomial Trees
 Assume the following inputs:
 S0 = 100, X = 98, σ = 20% pa, rF = 5% pa, T = 1.0 years
Distinct "States
Node (2,2) of the World"
132.69
w=2
Node (1,1) 34.69
115.19
Node (0,1) 19.61062 Node (2,1)
100 100.00
w=1
11.064 Node (1,0) 2.00
86.81
1.080 Node (2,0)
75.36
w=0
0.00
Node Time:
0.0 0.5 1.0

Node Upper value = Stock Price

Node Lower value = Option Price
Risk Neutral Binomial Trees
 Firstly, calculate the value for u and d
u = 1.1519, d = 1/u = 0.8681

 Next, populate the stock price values, going from left to

right:
 Node(1,1) Stock price = S0u = 115.19
 Node(2,1) Stock price = S0ud = S0du = 100

 Now calculate the terminal option price values

 Node(2,2) Option Price = max(ST-X,0) = 132.69-98 = 34.69
 Node(2,1) Option Price = max(ST-X,0) = 100.00-98 = 2.00
 Node(2,0) Option Price = max(ST-X,0) = 75.36-98 = zero
Risk Neutral Binomial Trees
 Now calculate the intervening option prices going
from right to left
 Node(1,1) OP = e-0.05(0.5) [34.68x0.5539+2x0.4461] = 19.6106
 Node(1,1) OP = e-0.05(0.5) [2x0.5539-0x0.4461] = 1.080

 And finally the current (t=0) option price

 Node(0,0) OP = e-0.05(0.5) [19.6106x0.5539- 1.080 x0.4461]
 = 11.064
 Risk Neutral Binomial Trees
 Notice the sum of the risk neutral probabilities

Probability Description
state
w=2 Two up probabilities in = p.p = 0.3068
succession
w=1 Up followed by down or = p.u or u.p = 0.4942
down followed by up
w=0 Two down probabilities in = d.d = 0.1990
succession
Total = 1.000
 Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 17