More on Models and
Numerical Procedures
Chapter 26
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John C. Hull 2008 1
Three Alternatives to Geometric
Brownian Motion
Constant elasticity of variance (CEV)
Mixed Jump diffusion
Variance Gamma
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CEV Model (page 592 to 593)
dS (r q) Sdt S dz
◦ When = 1 the model is Black-Scholes
◦ When > 1 volatility rises as stock
price rises
◦ When < 1 volatility falls as stock price
rises
European option can be value
analytically in terms of the cumulative
non-central chi square distribution
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CEV Models Implied Volatilities
imp
<1
>1
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Mixed Jump Diffusion Model
(page 593 to 594)
Merton produced a pricing formula when the asset price follows a diffusion process overlaid with
random jumps
◦ dp is the random jump
◦ k is the expected size of the jump
dS / S (r q k )dt dz dp
◦ dt is the probability that a jump occurs in the next interval of length dt
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Jumps and the Smile
Jumps have a big effect on the implied
volatility of short term options
They have a much smaller effect on the
implied volatility of long term options
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The Variance-Gamma Model
(page 594 to 595)
Define g as change over time T in a variable
that follows a gamma process. This is a
process where small jumps occur frequently
and there are occasional large jumps
Conditional on g, ln ST is normal. Its
variance proportional to g
There are 3 parameters
◦ v, the variance rate of the gamma process
◦ the average variance rate of ln S per unit time
◦ a parameter defining skewness
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Understanding the Variance-
Gamma Model
g defines the rate at which information
arrives during time T (g is sometimes
referred to as measuring economic time)
If g is large the change in ln S has a
relatively large mean and variance
If g is small relatively little information
arrives and the change in ln S has a
relatively small mean and variance
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Time Varying Volatility
Suppose the volatility is 1 for the first year
and 2 for the second and third
Total accumulated variance at the end of
three years is 12 + 222
The 3-year average volatility is
2
2 2
32 12 222 ; 1 2
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Stochastic Volatility Models
(equations 26.2 and 26.3, page 597)
dS
(r q )dt V dz S
S
dV a (VL V )dt V dzV
When V and S are uncorrelated a
European option price is the Black-Scholes
price integrated over the distribution of the
average variance
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Stochastic Volatility Models
continued
When V and S are negatively correlated we
obtain a downward sloping volatility skew
similar to that observed in the market for
equities
When V and S are positively correlated the
skew is upward sloping. (This pattern is
sometimes observed for commodities)
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The IVF Model (page 598)
The implied volatility function model is
designed to create a process for the asset
price that exactly matches observed option
prices. The usual geomeric Brownian motion
model
dS (r q ) Sdt Sdz
is replaced by
dS [r (t ) q (t )]Sdt ( S , t ) Sdz
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The Volatility Function (equation
26.4)
The volatility function that leads to the
model matching all European option prices
is
[( K , t )]
2
cmkt t q (t )cmkt K [r (t ) q (t )] cmkt K
2
K 2 ( 2 cmkt K 2 )
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Strengths and Weaknesses of
the IVF Model
The model matches the probability
distribution of asset prices assumed by the
market at each future time
The models does not necessarily get the
joint probability distribution of asset prices
at two or more times correct
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Convertible Bonds
Often valued with a tree where during a
time interval t there is
◦ a probability pu of an up movemen
◦ A probability pd of a down movement
◦ A probability 1−exp(−t) that there will be a
default ( is the hazard rate)
In the event of a default the stock price
falls to zero and there is a recovery on the
bond
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2008 15
The Probabilities
a de t
pu
ud
ue t a
pd
ud
( 2 ) t
ue
1
d
u
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2008 16
Node Calculations
Define:
Q1: value of bond if neither converted nor
called
Q2: value of bond if called
Q3: value of bond if converted
Value at a node =max[min(Q1,Q2),Q3]
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2008 17
Example 26.1 (page 600)
9-month zero-coupon bond with face value
of $100
Convertible into 2 shares
Callable for $113 at any time
Initial stock price = $50,
volatility = 30%,
no dividends
Risk-free rates all 5%
Default intensity,, is 1%
Recovery rate=40%
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2008 18
The Tree (Figure 26.2, page 601)
G
76.42
D 152.85
66.34
B 132.69 H
57.60 57.60
A 115.19 E 115.19
50.00 50.00
106.93 C 106.36 I
43.41 43.41
101.20 F 100.00
37.68
98.61 J
32.71
100.00
Default Default Default
0.00 0.00 0.00
40.00 40.00 40.00
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Numerical Procedures
Topics:
Path dependent options using tree
Barrier options
Options where there are two stochastic
variables
American options using Monte Carlo
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Path Dependence:
The Traditional View
Backwards induction works well for
American options. It cannot be used for
path-dependent options
Monte Carlo simulation works well for path-
dependent options; it cannot be used for
American options
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Extension of Backwards
Induction
Backwards induction can be used for
some path-dependent options
We will first illustrate the methodology
using lookback options and then show
how it can be used for Asian options
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Lookback Example (Page 602-603)
Consider an American lookback put on a stock
where
S = 50, = 40%, r = 10%, t = 1 month & the life
of the option is 3 months
Payoff is Smax−ST
We can value the deal by considering all possible
values of the maximum stock price at each node
(This example is presented to illustrate the methodology. It is not
the most efficient way of handling American lookbacks (See
Technical Note 13)
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Example: An American Lookback
Put Option (Figure 26.3, page 603)
S0 = 50, = 40%, r = 10%, t = 1 month,
70.70
70.70
62.99 0.00
62.99 56.12
56.12
3.36 62.99 56.12
56.12 50.00 6.87 0.00
50.00
4.68 A
5.47
56.12 50.00 44.55
44.55
6.12 2.66 56.12 50.00
50.00 11.57 5.45
39.69
6.38
50.00
35.36
10.31 50.00
14.64
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Why the Approach Works
This approach works for lookback options because
The payoff depends on just 1 function of the path
followed by the stock price. (We will refer to this
as a “path function”)
The value of the path function at a node can be
calculated from the stock price at the node & from
the value of the function at the immediately
preceding node
The number of different values of the path function
at a node does not grow too fast as we increase
the number of time steps on the tree
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Extensions of the Approach
The approach can be extended so that
there are no limits on the number of
alternative values of the path function at a
node
The basic idea is that it is not necessary to
consider every possible value of the path
function
It is sufficient to consider a relatively small
number of representative values of the
function at each node
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Working Forward
Firstwork forward through the tree
calculating the max and min values of the
“path function” at each node
Next choose representative values of the
path function that span the range between
the min and the max
◦ Simplest approach: choose the min, the max,
and N equally spaced values between the min
and max
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Backwards Induction
We work backwards through the tree in the
usual way carrying out calculations for each
of the alternative values of the path function
that are considered at a node
When we require the value of the derivative
at a node for a value of the path function
that is not explicitly considered at that node,
we use linear or quadratic interpolation
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Part of Tree to Calculate
Value of an Option on the
Arithmetic Average S = 54.68
(Figure 26.4, page 605)
Y Average S Option Price
47.99 7.575
51.12 8.101
0.5056 54.26 8.635
57.39 9.178
S = 50.00
Average S Option Price
46.65 5.642 X
49.04 5.923
S = 45.72
51.44 6.206
53.83 6.492 Average S Option Price
0.4944 43.88 3.430
46.75 3.750
49.61 4.079
S=50, X=50, =40%, r =10%, Z 52.48 4.416
T=1yr, t=0.05yr. We are at time
4t Options, Futures, and Other
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Part of Tree to Calculate Value of an
Option on the Arithmetic Average
(continued)
Consider Node X when the average of 5
observations is 51.44
Node Y: If this is reached, the average becomes
51.98. The option price is interpolated as 8.247
Node Z: If this is reached, the average becomes
50.49. The option price is interpolated as 4.182
Node X: value is
(0.5056×8.247 + 0.4944×4.182)e–0.1×0.05 = 6.206
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Using Trees with Barriers
(Section 26.6, page 606)
When trees are used to value
options with barriers, convergence
tends to be slow
The slow convergence arises from
the fact that the barrier is
inaccurately specified by the tree
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True Barrier vs Tree Barrier for a
Knockout Option: The Binomial Tree Case
Tree Barrier
True Barrier
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Inner and Outer Barriers for Trinomial
Trees (Figure 26.4, page 607)
Outer barrier
True barrier
Inner Barrier
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Alternative Solutions
to Valuing Barrier Options
Interpolate between value when inner
barrier is assumed and value when
outer barrier is assumed
Ensure that nodes always lie on the
barriers
Use adaptive mesh methodology
In all cases a trinomial tree is preferable
to a binomial tree
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Modeling Two Correlated
Variables (Section 26.7, page 609)
APPROACHES:
1. Transform variables so that they are not
correlated & build the tree in the transformed
variables
2. Take the correlation into account by
adjusting the position of the nodes
3. Take the correlation into account by
adjusting the probabilities
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Monte Carlo Simulation and
American Options
Two approaches:
◦ The least squares approach
◦ The exercise boundary parameterization
approach
Consider a 3-year put option where the
initial asset price is 1.00, the strike price is
1.10, the risk-free rate is 6%, and there is
no income
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Sampled Paths
Path t = 0 t =1 t =2 t =3
1 1.00 1.09 1.08 1.34
2 1.00 1.16 1.26 1.54
3 1.00 1.22 1.07 1.03
4 1.00 0.93 0.97 0.92
5 1.00 1.11 1.56 1.52
6 1.00 0.76 0.77 0.90
7 1.00 0.92 0.84 1.01
8 1.00 0.88 1.22 1.34
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The Least Squares Approach
(page 612)
We work back from the end using a least
squares approach to calculate the
continuation value at each time
Consider year 2. The option is in the money
for five paths. These give observations on S
of 1.08, 1.07, 0.97, 0.77, and 0.84. The
continuation values are 0.00, 0.07e-0.06,
0.18e-0.06, 0.20e-0.06, and 0.09e-0.06
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The Least Squares Approach
continued
Fitting a model of the form V=a+bS+cS2 we
get a best fit relation
V=-1.070+2.983S-1.813S2
for the continuation value V
This defines the early exercise decision at
t =2. We carry out a similar analysis at t=1
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The Least Squares Approach
continued
In practice more complex functional forms
can be used for the continuation value and
many more paths are sampled
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The Early Exercise Boundary
Parametrization Approach (page 615)
We assume that the early exercise boundary can
be parameterized in some way
We carry out a first Monte Carlo simulation and
work back from the end calculating the optimal
parameter values
We then discard the paths from the first Monte
Carlo simulation and carry out a new Monte Carlo
simulation using the early exercise boundary
defined by the parameter values.
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Application to Example
We parameterize the early exercise
boundary by specifying a critical asset
price, S*, below which the option is
exercised.
At t =1 the optimal S* for the eight paths is
0.88. At t =2 the optimal S* is 0.84
In practice we would use many more paths
to calculate the S*
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