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Derivatives
1 2 2
S dt
dt + f = K
2
and hence (recalling definition):
1
2
]dt
P &L = S 2[t2 K
2
C 1 2C 2 2 C
C
dC =
+
S +
S +
t
2 S 2 t
S
K
C
C
2C
1 2C 2
+
2 t + S t St dt + S t SdZ1 + t dZ2
2 K
K
K
or, writing the partial derivatives as Greeks:
1
1 2 2
2
dC = + t S + S + V + Wt + X tSt dt + tSdZ1 + VtdZ2
2
2
where V is the Vega, X is the vanna and the W is the volga.
1 2 2
1
d
f
2
d = + t S +(r r )S+V+ Wt +X tSt dtrdCdt+VtdZ2
2
2
d =
V(dk
dt)
0.0600
0.0045
0.0040
0.0500
0.0035
0.0400
0.0030
0.0025
0.0300
0.0020
0.0015
0.0200
0.0010
52
0.0005
0.0100
96
1.41
1.38
1.35
1.29
1.32
1.23
1.26
1.20
1.13
1.16
1.10
1.04
1.4
1
1.3
9
1.3
7
1.3
5
1.3
2
1.3
0
0.0000
1.07
spot
1.2
8
1.2
6
1.2
3
1.2
1
1.1
9
1.1
6
1.1
4
1.1
2
1.1
0
-0.0005
139
1.0
7
1.0
5
0.0000
183
time to
(
0.1000
0.0500
0.0200
0.0000
0.0000
1.0
5
1.0
7
1.1
0
1.1
2
1.1
4
1.1
6
1.1
9
1.2
1
1.2
3
1.2
6
1.2
8
1.3
0
1.3
2
1.3
5
1.3
7
1.3
9
1.4
1
-0.0500
-0.0200
-0.1000
-0.1500
-0.0400
-0.2000
8
-0.2500
-0.0600
52
-0.3000
96
-0.0800
-0.3500
139
1.41
1.38
1.35
1.29
1.32
1.26
1.20
1.23
1.16
1.10
1.13
spot
1.04
-0.1000
1.07
-0.4000
183
time to
6.0000
2.5000
5.0000
2.0000
4.0000
1.5000
3.0000
2.0000
1.0000
1.0000
0.5000
0.0000
1.4
1
1.3
9
1.3
7
1.3
5
1.3
2
1.3
0
1.2
8
1.2
6
1.2
3
1.2
1
1.1
9
1.1
6
1.1
4
1.1
2
1.1
0
-0.5000
-1.0000
1.0
7
1.0
5
0.0000
52
-2.0000
96
-3.0000
-1.0000
139
1.41
1.38
1.35
1.29
1.32
1.26
1.20
1.23
1.16
1.10
1.13
spot
1.04
-1.5000
1.07
-4.0000
183
time to
40.0000
2.0000
30.0000
1.5000
20.0000
1.0000
0.5000
10.0000
0.0000
8
1.4
1
1.3
9
1.3
7
1.3
5
1.3
2
1.3
0
1.2
8
1.2
6
1.2
3
1.2
1
1.1
9
1.1
6
1.1
4
1.1
2
1.1
0
-0.5000
1.0
7
1.0
5
0.0000
52
-10.0000
96
-1.0000
139
1.38
1.41
1.32
1.35
1.26
1.29
1.23
1.16
1.20
1.10
1.13
spot
1.04
-1.5000
1.07
-20.0000
183
time t
0.1200
0.0350
0.1000
0.0300
0.0250
0.0800
0.0200
0.0600
0.0150
0.0400
0.0100
5
26
0.0050
0.0200
48
0.0000
1.33
1.35
1.28
1.30
1.24
1.26
1.20
1.22
1.18
1.14
1.16
1.09
spot
1.11
1.1
0
1.1
1
1.1
3
1.1
5
1.1
6
1.1
8
1.1
9
1.2
1
1.2
3
1.2
4
1.2
6
1.2
7
1.2
9
1.3
0
1.3
2
1.3
4
1.3
5
69
0.0000
91
time to
(d
0.2000
0.1000
0.1000
0.0000
1.1
0
1.1
1
1.1
3
1.1
5
1.1
6
1.1
8
1.1
9
1.2
1
1.2
3
1.2
4
1.2
6
1.2
7
1.2
9
1.3
0
1.3
2
1.3
4
1.3
5
0.0000
-0.1000
-0.1000
-0.2000
-0.2000
-0.3000
-0.3000
-0.4000
-0.4000
5
26
48
-0.5000
-0.5000
69
1.33
1.35
1.28
1.30
1.26
1.22
1.24
1.18
1.20
1.16
1.11
spot
1.14
-0.6000
1.09
-0.6000
91
time to
(
10.0000
8.0000
8.0000
6.0000
6.0000
1.3
5
1.3
4
1.3
2
1.3
0
1.2
9
1.2
7
1.2
6
1.2
4
1.2
3
1.2
1
1.1
9
-2.0000
1.1
8
0.0000
1.1
6
0.0000
1.1
5
2.0000
1.1
3
2.0000
1.1
1
4.0000
1.1
0
4.0000
5
-2.0000
26
48
-4.0000
-4.0000
69
1.35
1.33
1.30
1.26
1.28
1.22
1.24
1.20
1.16
1.18
1.14
spot
1.09
-6.0000
1.11
-6.0000
91
time to
(
35.0000
8.0000
30.0000
6.0000
25.0000
4.0000
20.0000
2.0000
15.0000
1.3
5
1.3
4
1.3
2
1.3
0
1.2
9
1.2
7
1.2
6
1.2
4
1.2
3
1.2
1
1.1
9
1.1
8
1.1
6
1.1
5
1.1
3
-2.0000
1.1
1
1.1
0
0.0000
10.0000
5.0000
-4.0000
5
0.0000
-6.0000
26
-5.0000
-8.0000
48
-10.0000
-10.0000
69
1.35
1.33
1.30
1.26
1.28
1.24
1.20
1.22
1.18
1.14
1.16
spot
1.09
-12.0000
1.11
-15.0000
91
time to
Up&Out call
Down&Out put
25 put
79,008,643
-400,852,806
25 call
54,195,790
-197,348,566
ATM put
-127,556,533
496,163,095
1W
2W
1M
2M
3M
6M
9M
1Y
2Y
AT M
13.50%
11.80%
11.95%
11.55%
11.50%
11.30%
11.23%
11.20%
11.10%
RR
0.00%
0.00%
0.05%
0.15%
0.15%
0.20%
0.23%
0.25%
0.20%
V W B
0.19%
0.19%
0.19%
0.21%
0.21%
0.23%
0.23%
0.24%
0.25%
P d(0, T )
0.9997974
0.9995851
0.9991322
0.9981532
0.9972208
0.9941807
0.9906808
0.9866905
0.9626877
P f (0, T )
0.9996036
0.9992202
0.9983883
0.9966665
0.9951018
0.9902598
0.9855211
0.9807808
0.9550092
Up&Out call
Down&Out put
25 put
76,409,972
-338,476,135
25 call
42,089,000
-137,078,427
ATM put
-117,796,515
413,195,436
More Risks
Other risks, related to plain vanilla and exotic options, have to be managed
P (Rho) and exposure, i.e.: the sensitivity of the option price to the
domestic interest rate and the foreign interest rate, or dividend yield in
case of equity option.
Risks related to some exotics, e.g.: gap at the breach of the barrier.
Correlation risk: many exotic options (especially in the equity market)
have as underlying basket of stocks, or the pay-off is contingent on the
future evolution of a given number of stocks. In these cases, correlation
between the single assets become a main risk.
Correlation Risk
As an example of correlation risk, we discuss three different option types
with the following payout structures
An at-the-money (ATM) call option on an equally weighted basket of n
stocks.
An option on the maximum performance of n assets
An option on the minimum performance of n assets.
Payouts are defined relative to Si, i = 1, .., n i.e.: the asset price at the
expiry T = 0.
Correlation Risk
The risk management of multi-asset options implies the canceling of the
first and second order spot and volatility sensitivities, though in this case
we have to deal with matrices of sensitivities :
The vector
C
Si
The matrix
C
Si Sj
C
i
C
i j
C
i Sj
Correlation Risk
Single stocks and plain vanilla options on single stocks hedge only the
the Vega and the diagonal elements of the , Volga and Vanna matrix.
The remaining risks, i.e. the nondiagonal elements (cross , cross Volga
and cross Vanna) and the correlation Vega, can be hedged only by other
multi-asset options.
It can be shown that in a B&S world the following relationship holds:
C
C
= Si Sj i j T
ij
SiSj
So that by hedging all the cross exposure one hedges also the correlation
Vega exposures.
Correlation Risk
The correlation risk affects the price of an options in two ways, depending
also on the kind of pay-off of the structure:
It impacts on the volatility of the entire basket of underlying stocks.
It impacts on the dispersion of the single stocks within the basket.
We make some intuitive considerations on these two effects with respect to
the three kind of exotic options we listed above.
Correlation Risk
Basket options:
The value of the option is affected only by the basket volatility.
The dispersion of individual assets does not influence the option price,
because the payout only depends on the sum of the asset prices at
maturity.
Higher correlations increase basket volatility and thus the option price.
Hence basket options are long in correlation.
Correlation Risk
Options on the Maximum:
Increasing correlations imply higher volatility of the basket
Increasing dispersion of the single stocks increases the probability of any
stock to reach a very high value at maturity. This effect grows with
declining correlations.
So for max options, the two effects operate in opposite directions.
From moderate to high correlation, option prices decrease with increasing
correlation: hence, the dispersion effect is stronger than the basket
volatility effect and the max option is short in correlation.
It should be stressed that this is the initial exposure when the Si(0) are
fixed. Situations can occur where the max option is both short and long
in correlation depending on the specific levels of correlation and spot
prices.
Correlation Risk
Options on the Minimum:
The min option is affected by both effects, but both take the same
direction in this case.
The dispersion effect increases option prices as correlations become
higher, since this minimizes the probability that any asset reaches a very
low level at maturity and maximizes the value of the min option
Higher correlation implies also a higher volatility of the basket and this
increase the option value.
Since both effects operate in the same direction, the correlation sensitivity
is positive and especially high for this option type.