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Paul Staneski
Black--Scholes or Black Holes?
Black
1
It’s a Model!
Slide 2
2
Some Issues
Variance Swaps
– Short-term vs. long-term replication
Slide 3
3
Black-Scholes
The “Black-Scholes” model rivals CAPM (the Capital Asset Pricing Model) as
the most important result in the history of finance.
– Fischer Black and Myron
y Scholes, “The Pricing
g of Options
p and Corporate
p Liabilities”,
Journal of Political Economy, 81 (May-June 1973), pp. 637-659.
– Scholes and Robert Merton won the 1997 Nobel Prize in Economics for this work
(Black died in 1995 and the prizes are not awarded posthumously).
Slide 4
4
Black-Scholes in a Nutshell
Option ∆Stock
Slide 5
5
The Greeks are Key!
Slide 6
6
Delta Hedging & Gamma
Loss on Call
Loss on Hedge
Stock Price
Because of gamma
gamma, the hedged position has a net gain regardless of the move in spot
spot.
Slide 7
7
Capturing Gamma
P/L
S1 S2
Stock Price
Initial Premium
Gamma “captured”
Slide 8
8
Capturing (More) Gamma
P/L
S3 S1 S2
Stock Price
Initial Premium
Gamma “captured”
captured
Gamma “captured”
Slide 9
9
Model Assumptions
Under all the model’s assumptions (there are many!) the application of the
model to a 10-day option is not at all different than its application to a 10-year
option.
However, in the “real world” this time invariance is not the case!
The “troublesome”
troublesome assumptions …
Constant interest rates (and dividends)
Constant volatility
Slide 10
10
Question
– Answer: ____________
Slide 11
11
Answer
Not necessarily!
You expect
p to make money,
y, but given
g the particular
p price
p path
p of the stock
you might not.
Slide 12
12
Where’s your gamma?
Slide 13
13
Gamma and Time
X = 100, vol = 16%, r = 4%
0.05
t = 0.25
0.04
0.03
ma
Gamm
0.02
t=1
01
0.0
0.0
Slide 14
14
Non-Constant Gamma
Large volumes generally ensure that the “expected” nature of hedging profits
prevails.
However,
However because many fewer long
long-dated
dated options are traded this “averaging”
averaging
out may not occur.
Slide 15
15
More Greeks: Vega and Rho
Slide 16
16
Vega and Rho
Question: Why does the put value rise then begin to decline? Slide 17
17
Vega vs. Rho over Time
Rho increases absolutely with time but vega actually starts to decline …
Slide 18
18
Vega/Put vs. Rho/Put
Slide 19
19
Hedging Rho
For short-dated options, and especially in this low rate and low rate-vol
environment, rho is not a big concern for equity-option traders.
Rho risk that is generated by trading equity options can be hedged with FRAs
and Eurodollar Futures.
For long-dated
long dated options,
options as we have seen
seen, rho risk becomes significant and this
long-dated rate risk is not as easily hedged.
– A 100 bp change in rates is very unlikely in the next 3 months, but is virtually certain
over the next 10 years.
Slide 20
20
Stochastic Interest Rates
Interest-rate sensitive derivatives can be priced with a model that allows for the
evolution of rates (“stochastic” interest rates) over time.
Slide 21
21
More Questions
Is vol dependent
p on the level of rates?
– Are the vols of spot rates and forward rates different?
Slide 22
22
Basic Model Structure
Models that “fit the market” all suffer from the same problems as Black-
S h l
Scholes: h
hedging
d i llong-dated
d d iinstruments iis diffi
difficult.
l
Slide 23
23
One-Factor Interest Rate Models
All of these models do a reasonable job of pricing, but alone do not provide
adequate hedging strategies.
strategies
Slide 24
24
Variance Swaps
Variance Swap: a contract that pays the difference between the realized
variance and a fixed level of variance (the “strike”).
– Payoff = M (Realized Variance Ӎ Strike Variance)
M*(Realized
Note 1: The strike is quoted in vol terms (20%, for example) even though the
contract is valued as the difference between variances.
Slide 25
25
Replicating/Hedging a Variance Swap
Strike
Out-of-the-money Puts F Out-of-the-money Calls
Slide 26
26
Short vs. Long-Dated Variance Swaps
For short-dated swaps ( < 1 year), such options trade with sufficient liquidity on
major indices.
For long-dated
long dated swaps,
swaps it is hard to hedge properly and market makers thus try
to match buyers with sellers.
Slide 27
27
Valuing an Option: Inputs
S
X
r Valuation Model
Option Value
V l
(Black-Scholes?)
t
σ
Slide 28
28
Option Pricing Models ?
Slide 29
29
Implied Volatility
We can “reverse-engineer” the model to solve for the volatility that would
produce this price (along with the other known inputs) …
Slide 30
30
Realized Volatility
σR A
r i
2
A Periodic Vol
N
– Where ri are log periodic returns (usually daily); e.g. ri = log(Pi /Pi – 1)
– N is the number of returns in the calculation.
– A is the number of periods in a year (A = 252 for daily data).
“Realized vol” can be different with different choices of the above, especially
p y
the periodicity.
Slide 31
31
What was realized volatility?
Slide 32
32
Question
Slide 33
33
Realized vs. Implied
34
Implied Vol is “More” than Vol
Implied volatility, as the only number you can “change” in the Black-Scholes
Model, embeds all the deviations from the assumptions of the model …
– Skewness ((out-of-the-moneyy pput vol is usuallyy > otm call vol))
Aka “volatility smiles”
– Kurtosis (“fat tails”).
– Inabilityy to hedge
g continuously.
y
– We own options “continuously” but calculate realized vol at a discrete periodicity (you
can buy and sell an option intra-day, making day-to-day realized vol immaterial).
Implied
I li d voll iis ““contaminated”
t i t d” b by allll off th
the above.
b
Slide 35
35
Questions
1. If the 2500 largest realized vol days from the last 50 years were
concatenated into a single 10-year period, what would be the realized vol of
this “wild decade”?
– Answer: ____________
2. What is the realized vol of the past decade (which includes two of the most
volatile markets in history)?
– Answer: ____________
3.
3 What is the a erage long-term
average long term level
le el of reali
realized
ed vol?
ol?
– Answer: ____________
Slide 36
36
Answers
1. If the 2500 largest realized vol days from the last 50 years were
concatenated into a single 10-year period, what would be the realized vol of
this “wild decade”?
– Answer: _____29%____
2. What is the realized vol of the past decade (which includes two of the most
volatile markets in history)?
– Answer: _____22%_____
3.
3 What is the a erage long-term
average long term level
le el of reali
realized
ed vol?
ol?
– Answer: _____16%_____
Slide 37
37
Pricing on a 29 Vol …
Slide 38
38
Pricing on a 22 Vol …
Slide 39
39
Pricing on a 16 Vol …
Slide 40
40
2005: C3P2-Driven Rise in 10-year Implied Vol
Slide 41
41
10-Year SPX Vol
Slide 42
42
Constant Volatility
dS μSdt σSdW
– Where …
“mu” is the drift (g
(growth rate)) of the stock.
“sigma” is the (constant) volatility.
“dt” is an increment of time.
“dW” is a random normal process (Weiner Process).
Slide 43
43
Geometric Brownian Motion
dS/S
μ (deterministic component)
+
σ (random component, which is “normal”)
time
dt
Slide 44
44
Stochastic Volatility: Heston Model
– Where
Wh (all
( ll else
l as b
before)
f )…
“lambda” is the mean reversion rate for the variance.
“theta” is the long-run level to which variance reverts.
“eta” is the volatilityy of variance.
dW1 and dW2 are correlated Weiner Processes.
Heston, S. L., “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond
and Currency”, The Review of Financial Studies, 1993.
Slide 45
45
Stochastic Vol
With Heston’s model, we can fit the vol skew and account for fat tails.
Slide 46
46
Slide 47
47
Contact Information
Slide 48
48