Numerical Determination of Exotic Option Prices

Diplom Thesis supervised by the

Swiss Banking Institute (ISB) at the University of Zurich

Prof. Dr. Thorsten Hens

Author: Esad Cekic Student ID: 03-714-276 Address: Blachhof 3/15, 8057 Zrich u u E-Mail: esad@gmx.ch

Abstract In this diplom thesis dierent numerical approaches are examined in terms of pricing the exotic options. It will be tested, which of the three numerical approaches (the trees, Monte Carlo simulation and nite dierence methods) approximates the exotic option price the most accurately. The focus will lie on the down-and-out put barrier option. Since the barrier option is very dicult to hedge, the investment banks shift the barrier when they price the exotic. It will be examined to what extent the barrier is shifted. Stated dierently, in terms of the down-and-out put, it will be shown by how much the down-and-out put is too expensive. It will be examined why and when a client will consider buying such an exotic. More generally, it will be shown that the investor can benet if the derivatives (plain vanilla options) are introduced into the portfolio. Simultaneously, it will be shown how the investment bank hedges such an exotic position, if at all, and additionally, it will be shown why an asset manager should / should not use such a product for hedging a portfolio. Finally, it will be examined if the structured products containing a plain vanilla option or a barrier option respectively, are fairly priced.

Contents
1 Introduction 2 Theory 2.1 Dierent types of the Exotics . 2.1.1 Binary Options . . . . . 2.1.2 Barrier Options . . . . . 2.1.3 Look back Options . . . 2.1.4 Asian Options . . . . . . 2.2 Dierent Numerical Approaches 2.2.1 The Trees . . . . . . . . 2.2.2 Monte Carlo Simulation 2.2.3 Finite Dierence Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 5 6 6 7 9 10 10 10 13 14 15 15 16 19 21 25 25 26 29 30 33 35 35 36 37 38 43 46 50 50 51 53

3 Empirical Part 3.1 Empirical Part 1: Application of the three numerical approaches 3.1.1 Plain vanilla option, European Call . . . . . . . . . . . 3.1.2 Convergence-Plain Vanilla Option . . . . . . . . . . . . 3.1.3 Barrier Option, Down-and-Out Put . . . . . . . . . . . 3.2 Empirical Part 2: How much do the IB shift the barrier? . . . 3.2.1 Brief review of the markets . . . . . . . . . . . . . . . . 3.2.2 Oer prices from the seven IBs . . . . . . . . . . . . . 3.2.3 The BS price overprice the market oer price strongly . 3.2.4 How do the IBs price a Barrier Option . . . . . . . . . 3.2.5 What does it mean when the Barrier is shifted 2.5-3%? 3.2.6 Barrier Option valuation, revisited . . . . . . . . . . . 3.2.7 Trinomial Tree, revisited . . . . . . . . . . . . . . . . . 4 Application Part 4.1 Application Part 1: Bonus Certicate . . . . 4.1.1 From clients point of view . . . . . . 4.1.2 From IBs point of view . . . . . . . 4.1.3 From Asset Managers point of view . 4.2 Application Part 2: Are SP fairly priced? . . 4.2.1 Introduction . . . . . . . . . . . . . . 4.2.2 Methods . . . . . . . . . . . . . . . . 4.2.3 Results . . . . . . . . . . . . . . . . . 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4.2.4 5 Conclusion

Discussion . . . . . . . . . . . . . . . . . . . . . . . . . 57 58

Introduction

In recent decades, the exotic options (exotics) have become constantly more important in the nancial sector and beyond it. Every bank uses/issues them actively whenever structuring is requested. For a bank, they are more protable than the plain vanilla options (options) due to their special payo which is slightly dierent compared to the options. The Black and Scholes[12] Formula1 (BS) was a signicant research breakthrough in the eld of pricing the options, or generally spoken, in the eld of pricing the derivatives. Since the exotics are slightly modied options in terms of their payo (in the case of the barrier options), it is important to understand how the options are priced before the pricing of an exotic is considered. For the path-depended options, an analytical closed pricing formula does not exist. Barrier options are path-dependent but the path-dependence is (very) weak, so that an analytical closed pricing formula exists. In this diplom thesis, the price obtained by this closed analytical formula is considered correct and will be regarded as benchmark, especially in the part where the numerical approaches are tested (Empirical Part 1). This diplom thesis is divided in three parts: the theoretical part, the empirical part and the application part, where the derived results are applied. In the rst subsection of the theoretical part, dierent types of the exotics are presented. In the second subsection, the dierent numerical approaches adequate for pricing the derivatives are reviewed. The empirical part itself is divided in two parts. In the empirical part 1 the dierent numerical approaches are applied for pricing a derivative and the convergence of the corresponding method to the BS price is shown. In a rst step a plain vanilla call is priced and then a down-and-out put is priced. In the empirical part 2 it will be shown to what extent the investment banks (IB) shift the barrier when they price such an exotic. It will be shown later why such a barrier bending is needed in the rst place. In the application part, the results obtained are applied. Since a private client does not have the opportunity to buy a barrier option exclusively, one structured product will be presented where a barrier option is a component of that product. The screening for the Swiss Market will be conducted in terms
Robert C. Merton has to be mentioned at this place since he contributed very much for the success of the Black and Scholes formula and nancial engineering in general with his paper[21] published parallel to the one of Black and Scholes. For the rest of the diplom thesis the BS abbreviation will be used though.
1

of which stock qualies as a good candidate for the underlying. From the clients point of view, it will be shown when a structured product with such a payo structure seems to be attractive. From the IBs point of view, it will be shown how such a position can be approached in terms of hedging. From the asset managers point of view, it will be shown why a barrier option could be used to hedge a portfolio, and why such a barrier option should not be used for this purpose. A more general study regarding the investors point of view and the inclusion of the derivatives into the portfolio, will be made. In the application part 2, it will be shown if the obtained results by Wilkens, Erner and Rder[5] and Stoimenov and Wilkens[4] hold as well for the Swiss o market. Both found that the structured products are not fairly priced and that the seller of the product is favored. Furthermore, they claim that the fairness decreases as the complexity and therefore the transparency of the Structured Product increases. In the conclusion the major ndings will be reviewed and the short summary of the whole thesis will be given.

Theory

The analytical pricing formula developed by Black and Scholes might be looked at as a pricing formula for a portfolio consisting of two options: an asset-or-nothing-option and cash-or-nothing-option. Therefore the call option priced by the BS formula, for instance, consists of two exotics. Here, the analytical BS formula is briey reviewed c = S0 N (d1 ) Kert N (d2 )

p = Kert N (d2 ) S0 N (d1) where c and p denote the European Call and Put option respectively. S0 is the initial asset price, K is the strike, r is the risk free rate, N (d1 ) is the cumulative normal distribution function and d2 = d1 T , where is the volatility and T is the maturity of the option. As already mentioned in the introduction, the exotics exhibit a very similar structure to the plain vanilla options, but they also embody at least one feature, which distinguish them signicantly from the corresponding plain vanilla option. For instance for a barrier option, down-and-out put, the exotic is kind of a part of the corresponding plain vanilla option according to 5

the in-out parity. (Opv = Oin +Oout , where pv stands for plain vanilla). Since the exotic exists only if a certain barrier is not touched (in the case of downand-out put), the price of the exotic is less than the price of the corresponding plain vanilla option. Moreover, the exotics are nonstandard derivatives, thus traded over-the-counter. These two properties make the exotics (at least in this case) compared to the options, less valuable (cheaper) and therefore more attractive as a building component of a derivative product, which could be looked at as a portfolio. In the following subsection dierent types of the exotics are presented. Clearly, there are more exotics traded in the markets than will be presented below. As already said, the exotics are nonstandard derivatives and therefore the creativeness and innovation ability of the marketers on the one hand and the needs of the clients on the other hand, make sure that new types of the exotics always get created.

2.1

Dierent types of the Exotics

In this part dierent exotics are presented2 . 2.1.1 Binary Options

) Asset-Or-Nothing-Option[26] The exotic pays only if the derivative closes in the money (ITM) and nothing else. The respective payo at the expiry is for Call: c= Put: p= ST , if ST < K 0, otherwise ST , if ST > K 0, otherwise

) Cash-Or-Nothing-Option[27] The exotic pays a x amount M only if the exotic closes ITM. The respective payo at the expiry is for
The following homepage gives a nice overview over the exotics considered in this subsection http://www.sitmo.com/
2

Call: c= Put: p= M, if ST < K 0, otherwise M, if ST > K 0, otherwise

2.1.2

Barrier Options

There are three dierent characteristics, which need focus when a barrier option[28] is considered. The option is either call or a put, either up or down and either in or out. The characteristic up (down) indicates that the barrier is above (below) the initial stock price and the characteristic in (out) indicates that option starts (ceases) to exist when the certain barrier is breached. Further down the exotic type with the respective payo formula is presented. ) Down-and-in Call max(ST K, 0) if min (St ) B
0tT

) Down-and-out Call max(ST K, 0) if min (St ) B

0tT

) Up-and-in Call max(ST K, 0) if min (St ) B

0tT

) Up-and-out Call max(ST K, 0) if min (St ) B

0tT

) Down-and-in Put max(K ST , 0) if min (St ) B

0tT

) Down-and-out Put max(K ST , 0) if min (St ) B

0tT

) Up-and-in Put max(K ST , 0) if min (St ) B

0tT

) Up-and-out Put max(K ST , 0) if min (St ) B

0tT

Similarly to the put-call-parity, there exists a parity relation for barrier options, which is very important and useful for their pricing. Opv = Oin + Oout That means, e.g, once a down-and-out put price is obtained, the down-and-in put price can be deduced. It makes sense to divide the barrier options in two groups: the intrinsic and non-intrinsic barrier options. The non-intrinsic options are those, which do not have any intrinsic value when the barrier is breached. For instance the down-and-in call is a non-intrinsic option since the barrier is set at a level below the strike price when the option is issued. So when the option starts to exist, there is no intrinsic value in it. Contrastingly, the intrinsic options, they do have an intrinsic value when the barrier is breached. So, for instance, the up-and-out call is an intrinsic option since the barrier is set at a level above the strike price when the option is issued. That indicates that the option loses all the intrinsic value once the barrier is touched. In the table below the intrinsic and non-intrinsic barrier options types are summarized. non-intrinsic intrinsic down-and-out call up-and-out call down-and-in call up-and-in call up-and-out put down-and-out put up-and-in put down-and-in put Additionally, there are several variations of the barrier option type. 8

1. Regarding the monitoring of the barrier option: the barrier could be monitored on a daily basis, e.g the closing level, or on a continuous basis. If the barrier is monitored once a day, the barrier option is more expensive. 2. Regarding the number of the barriers: barrier option exists with more than just one barrier, e.g a double knock out barrier option is a barrier option, which knocks out if either of the barriers is breached and therefore cheaper than the barrier option with only one barrier. 3. Regarding the possibility of an early exercise: a barrier option might have the feature of an early exercise, which gives the option holder the right to exercise the option at any point before the maturity. It seems obvious that this feature allows the option to be almost as expensive as the plain vanilla option, since the option holder is going to exercise the option when the underlying seems to break through the barrier. 4. Regarding the rebates oer: If the barrier is breached for instance for the down-and-out put barrier option, the option holder might still get a certain amount, which is xed prior to the issue. This feature obviously again makes the barrier option more expensive. 2.1.3 Look back Options

For the look back options the distinction between a x and oating strike has to be done. ) Fixed Strike[29] c = max( max (St ) K, 0)
0tT

p = max(K min (St ), 0)

0tT

) Floating Strike[30] c = max(ST min (St ), 0)

0tT

p = max( max (St ) ST , 0)

0tT

2.1.4

Asian Options

Equally also for the Asian Options, the distinction between a x and oating strike has to be done. However in this case rather the average is taken into account so that the impact from the big movements of the underlying is reduced. The respective payo functions are given below, where AT = St,1 +St,2 +...+St,n1 +ST . n ) Fixed Strike[31] c = max(AT K, 0) p = max(K AT , 0) ) Floating Strike[32] c = max(ST AT , 0) p = max(AT ST , 0)

2.2

Dierent Numerical Approaches

In this subsection the dierent numerical approaches adequate for pricing a derivative are reviewed. The trees, the Monte Carlo simulation (MCS) and nite dierence method (FDM) are reviewed. 2.2.1 The Trees

) Binomial Trees The binomial tree is the one of the most applied and studied approaches for the pricing of the derivatives. This numerical approach is based on Cox, Ross and Rubinstein[13]. They assume that the price of the underlying either moves up (S u = S0 u) or down (S d = S0 d) after each time step. The 1 size of an up and down movement is u = e t and d = u respectively. The corresponding (risk neutral) probabilities for up (down) movements are rt d pu = e ud (pd = 1 pu ). Therefore the tree is recombinant and symmetric

10

as shown in the graph below.3

As the time step number increases, the time step size converges to zero and the option price converges to BS option price. ) Trinomial Trees Trinomial trees are based on Boyle[14]. The stock either moves up, down or does not change after each time step. Hence, the stock can take three dierent states: S u , S d and S m after each move and the corresponding probabilities 1 are then pu , pd and pm . Here in this case, u = e 3t , d = u , m = 0 and the corresponding probabilities are t/2 rt/2 e e pu = e t/2 e t/2 e t/2 ert/2 pd = e t/2 e t/2 pm = 1 pu pd .

When the terms of higher order t are ignored, then the probability can be rewritten as t 1 pu = (r 2 /2) + 2 12 6 The graph below shows such a trinomial tree for a stock with six time steps and S0 = K = 50, where S0 is the initial stock price and K is the strike price.
3

The graph has been taken from http://www.global-derivatives.com

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200 180 160 140 120 100 80 60 40 20 0

Asset Price

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Elapsed time

The convergence for the trinomial tree to the BS price is much faster then for the binomial tree. This will be proved in the empirical part 1. ) Trinomial Trees (Ritchken and Kamrad) It has already been said that plain vanilla options priced by the trinomial tree converge much faster to the BS price than the ones priced by the binomial tree. When the barrier options are considered this convergence slows down. Since the focus in this diplom thesis lies on the barrier options, the trinomial trees modication given by Ritchken and Kamrad [16] should be taken into account, which again speeds up the convergence process. The up, down and middle movements are multiplied by a certain factor u = e t , d = e t , and m = 0 and the corresponding probabilities are then pu =
1 22

t , 2

pd =

1 22

t , 2

pm = 1

1 2

where = r 0.5 2 . If = 1 then the modied trinomial tree becomes classical binomial tree and when = 3 the modied trinomial tree becomes the classical trinomial tree introduced by Boyle. indicates the spacing between the underlying movements from one time period to an other. In the graph below Kamrad and Ritchken show in their paper how the prices of the two models compared to the BS model deviate. They compare the accuracy of the two models for pricing the at-themoney (ATM) option, which is as well priced here in this diplom thesis. The size of the error of the trinomial tree model is in almost all cases smaller than the error obtained by the binomial tree model even though the binomial tree model has twice as much time steps. The trinomial model is slightly more time consuming and with the assumption about the number of the time 12

steps the two researches wanted to account for that. This empirical study presented below is done for the plain vanilla option.

2.2.2

Monte Carlo Simulation

The asset price process can be simulated by SDE equation, as shown in John C. Hulls book [1] S = St + SW or in the risk neutral world, where the expected return is replaced by risk free interest rate S = rSt + SW where W = t, which indicates the changes of the Brownian Motion. The more time steps are integrated in the model, respectively, the smaller the time step size is in the model, the closer the model comes to a real asset price movements. See the graphs below for three dierent time step numbers, 10, 30 and 365 respectively.
50.6 50.5 50.4 50.3 50.2 50.1 50 49.9
10 time steps

50.8 50.6 50.4 50.2 50 49.8 49.6 49.4

30 time steps

51 50 49 48 47 46 45 44 43 42 41

365 time steps

The left hand side of the equation above represents the asset changes, which are realized after each time step. The right hand side of the same equation denes the asset price moving process. So the rst part of the right hand side of the equation determines the drift (graph below on the left). The second part of the right hand side of the equation, which involves the Brownian Motion, determines the noise (graph in the middle). Both together determine how the asset price process evolves over time (graph on the right). In this example the following input data has been chosen: r = 0.1, S = K = 50, = 1 0.4, T = 1, timesteps = 365, t = 365 = 0.00274. 13

51.2 51 50.8 50.6 50.4 50.2 50 49.8 49.6 49.4

58 56 54 52 50 48 46 44 42 40

58 56 54 52 50 48 46 44 42 40

So far, only one asset path has been generated. Since the value of a call at the maturity is c = max(ST K, 0), a few more asset paths need to be generated so that the estimated call price gets close to the market call price. In the graph below 10 asset paths are generated. Later, in the empirical part vastly more asset paths are generated and compared with the BS price.
70 65 60 55 50 45 40 35 30

2.2.3

Finite Dierence Method

Finite Dierence Method (FDM) is the last numerical pricing method, which is going to be presented here. The starting equation for the FDM is the Partial Dierential Equation (PDE) of the BS-Formula: f 2f 1 f + rSt + 2 St2 2 = rf t S 2 S S(t) is the underlying asset price, f (S, t) is the unknown function of the derivative depending on both the asset price and the time. The solution of f (S, t) has to satisfy the PDE for every value S and t. The range for S and t needs to be dened. For that reason, the time and asset price partition as well as the maximum asset price level need to be determined. In the graphs below the time and asset partition are shown for values 1, 10 and 100. In the graph on the left (partition corresponds to one asset price change) and on the right (partition corresponds to one hundred asset price changes), a random path is shown so that the partitioning process is made clear. 14

Approximated call value surface

Approximated call value surface

50 40 Option value 30 20 10 0 0 Option value 0.5 60 80 100

50 40 30 20 10 0 0

0.5 60 80 100

Time to maturity

20

40 Asset price

Time to maturity

20

40 Asset price

The FDM can be divided in two parts: the implicit dierence method (IDM) and explicit dierence method (EDM). The point (i, j) represents a point on the grid, where i stands for t and j for S. It follows then that fi,j = f (it, jS). For IDM, fi,j+1 , fi,j , fi,j1 lead to fi+1,j , where for the EDM fi,j leads to fi+1,j+1 , fi+1,j , fi+1,j1 , which exactly matches the set up of the trinomial tree. IDM is very robust but the calculation is time consuming. EDM simplies the method, assuming that the rst and second derivatives of f respective to S are the same on the grid (i,j) and (i+1,j).

Empirical Part

In the theory part the dierent exotic options and the dierent numerical approaches have been presented. Here, in this part, the numerical approaches are applied and they will show the convergence to the BS price, which is assumed, at least here, to be correct. It will be proven that the trinomial tree converges much faster to the BS price when the plain vanilla option is considered. When a barrier option is considered, here the down-and-out put, it will be shown that the convergence for the trinomial tree model is better again, but that the convergence slows down and some modication speeds up the process again. In a rst step the numerical approaches are applied to price a plain vanilla option and then applied to price a barrier option. For the plain vanilla option only the call is considered, whereas for the barrier option, the down-and-out put is considered.

3.1

Empirical Part 1: Application of the three numerical approaches

For the modeled option prices the following parameters have been used: S0 = 50, K = 50, r = 0.1, = 0.4 and T = 1. Stated in words: the option is ATM, 15

time to maturity is one year, risk free rate is 10% and the volatility is 40%. As for all the graphs presented in this diplom thesis, I have used matlab4 , excel, bloomberg and ncad. 3.1.1 Plain vanilla option, European Call

) Binomial Tree In the graphs below the convergence of the option price to the BS price is shown as a function of the time partition. The more time steps are included, the closer the option price is to the BS price. The graph on the left shows the deviation from the BS price in absolute values, where the graph on the right shows the deviation in percentage of the BS price, which is assumed to be the correct price. When the time partition is more then 15, then the deviation from BS price is smaller then 2%.
12 11.5 11 10.5 0.5 10 0 9.5 9 8.5 8
1 2 3 4 5 6 7 8 9 10 15 20 25 30 35 40 45 50 60 70 80 90 100 120 140 160 180 200 250 300 350 400 450 500

2 1.5 1

12 11.5 11 10.5

17% 12% 7%

10 9.5
-0.5

2% -3%

9
-1 -1.5

8.5 8
1 2 3 4 5 6 7 8 9 10 15 20 25 30 35 40 45 50 60 70 80 90 100 120 140 160 180 200 250 300 350 400 450 500

-8%

) Trinomial Tree Trinomial trees, additionally to the binomial tree, introduce a price state after every time step, which does not change. As already mentioned, the trinomial tree option pricing is equivalent to the explicit nite dierence method shown in the previous section. Taking this additional feature, it is to be expected that the convergence to the BS price is much faster. The deviation from the BS price, which is less than 2% is already achieved after the time partition has been divided in 6 time steps. Compared to the binomial model, the deviation less than 2% is achieved after the time partition is set to 15. But, it has to been said that the trinomial tree is slightly more time consuming to be set up and calculated.
In the course[17] taught by Prof. Markus Leippold the application published on his unocial page has been used. The matlab application can be downloaded from the following page:http://leippold.googlepages.com. For few of my calculations I used this application. Rsli[20] gives in his semester thesis a good introduction to that application. o
4

16

Here again, the left graph shows the deviation in absolute values and the graph on the right the deviation in percent. Here the graph is more interesting compared to the previous one, since the trinomial tree approach seems to underestimate the call for every single time partition and therefore converges to the BS price from below.
10.4 10.2 10 9.8 9.6 9.4 9.2 9 8.8
1 2 3 4 5 6 7 8 9 10 15 20 25 30 35 40 45 50 60 70 80 90 100 120 140 160 180 200 250 300 350 400 450 500

0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1

10.4 10.2 10 9.8 9.6 9.4 9.2 9 8.8

1 2 3 4 5 6 7 8 9 10 15 20 25 30 35 40 45 50 60 70 80 90 100 120 140 160 180 200 250 300 350 400 450 500
11 10.5 10 9.5 9 8.5 250
11 10.5 10 9.5 9 8.5 250
1000 1250 1500

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

) Monte Carlo Simulation In this simulation below, I assumed 365 asset price changes per year since the year has 365 days. For this simulation, the random variable has been generated and then implemented in the asset price process equation. Since the value of the call option is f = (ST K, 0), the value of the option is dependent on the number of the generated asset price paths. The more asset price paths are generated, the less noise the option price exhibits. The graphs below show how the option value price changes dependent on dierent number (500, 1500, 3000 and 5000) of asset price paths.
11 10.5 10 9.5 9 8.5 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950 1000 11 10.5 10 9.5 9 8.5 250

500

750

500

750 1000 1250 1500 1750 2000 2250 2500 2750 3000

750

1250

1750

2250

2750

3250

3750

4250

4750

The simulated price after 1000 paths deviates less then 5% from the BS price, which here is assumed to be correct. After 3000 generated asset paths the deviation from the BS price is less than 2%.
11 10.5 10 9.5 9 8.5 250 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 -1 750 1250 1750 2250 2750 3250 3750 4250 4750
8.5 250 0% 750 1250 1750 2250 2750 3250 3750 4250 4750 9.5 9 4% 2% 10.5 10 8% 6% 11 10%

17

 )FDM The last method considered here is the FDM. The graphs presented below are divided in three steps. In FDM, the time and asset price have to be partitioned. In the rst case, the time partition is varied and the asset price partition is kept constant at 100. The maximal asset price is set at 100. The graph below shows that the option price evolves in the same manner as the option price when a trinomial tree is considered.
10.5 10 9.5 9 8.5 8 7.5 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0

10.5 10 9.5 9 8.5 8 7.5 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100

16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

Once the time partition has been varied and the asset price partition has been kept constant, here in the second case, the reverse case can be shown. That means that the asset price partition is varied and the time partition is kept constant at 100. The graphs below show that the option price evolves in the same manner as when the binomial tree is considered.
30 45.00% 40.00% 25 35.00% 20 15 20.00% 10 5 5.00% 0 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100 0.00% 15.00% 10.00% 30.00% 25.00%

30 25

4.5 4 3.5

20 15

3 2.5 2

10 5

1.5 1 0.5

0 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100

In the third and last case, both the asset price and the time partition is varied and this results then in a mixture model between the binomial and trinomial tree.
30 50.00% 45.00% 25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00%

30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

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3.1.2

Convergence-Plain Vanilla Option

In this subsection the convergence and the convergence speed is shown. ) Binomial Tree vs. Trinomial Tree Here the binomial and trinomial deviation are examined. In the graph below on the left, the deviation to the BS price are shown. The green column represent the binomial model, the blue column the trinomial model. It is clear that the deviation with the binomial model starts from a much higher level and for every single time partition stays higher. The graph on the right, represent the deviation reduction in percentage when more time steps are included. Equally, for instance, is the reduction of the deviation with binomial model lower when a second time step is included. Therefore, for example, if two time steps are included instead of one, the binomial price deviation reduces by 45% compared to the 47% reduction by the trinomial model. So, the binomial model starts from a higher level and reduces the deviation with a lower rate.
18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1 3 5 7 9 15 25 35 45 60 80 100 140 180 250 350 450

60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00%

2 4 6 8 10 20 12 0 16 0 20 0 30 0 40 0 50 0 50 70 90 30 40

) MCS Here the MCS is examined. In the left graph, the deviation from the BS price already encountered in the previous section is presented again. The deviation after 250 asset paths is quite small. However, because a random variable is included here in this model, the price of the option rises and falls through the whole graph. It seems that this up and down occurs all the time, but becomes smaller and smaller the more asset paths are included in the model. On the right graph, the deviation reduction in percent is presented. How should the graph on the right be interpreted? The closer the modeled price is to the BS price, the bigger is the relative deviation when a relative big price change occurs when one more asset price path is included in pricing of the option. Thus, i.e when 3755 asset price paths are included the option 19

deviation from the BS price is slightly above 1%. When one more path is included, the price deviates from the BS price more than 3%, which results in an increase for more than 300%. Therefore the changes above 100% have been truncated.
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 250 500 750 1000 1250 1500 1750 2000 2250 2500 2750 3000 3250 3500 3750 4000 4250 4500 4750 5000

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 251

751

1251

1751

2251

2751

3251

3751

4251

4751

Generally speaking, since a random variable is included in this model and no deviation reduction pattern exists, it is dicult to make a clear statement about the convergence and convergence speed. It can been said that the more asset price paths are included, the less noise the option price exhibits as a function of the asset paths. )FDM Here as well, the FDM is examined. On the left graph below, all the three deviations are shown. The green one shows the deviation when the asset partition is set equal to 100 and the time partition is varied. The blue one shows the deviations when the time partition is set equal to 100 and the asset price partition is varied. And the purple one shows the deviation when the time and asset price partition are changed at the same time. It is obvious that the one with the time variation has the lowest deviation from the BS price. (That is actually the explicit dierence method, or the trinomial tree.) The graph on the right shows the deviation reductions for all of them. Here as well, the same ones seem to be better than when the asset price is varied. When both are varied, the result obtained is not better that the one, where only the time is varied, which is intuitively clear.
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1 2 3 4 5 6 7 8 9 10 20 30 40 50 75 100 350% 300% 250% 200% 150% 100% 50% 0% 3 4 5 6 7 8 9 10 20 30 40 50 75 100

20

Generally, it can be said, that the best result is obtained when the asset partition is set high and the time is varied. Again, this method is EDM and is equal to the trinomial tree and will not be considered for the rest of the diplom thesis. 3.1.3 Barrier Option, Down-and-Out Put

In this part the numerical approaches, except from the FDM, will be tested for a barrier option. Since there are 8 dierent types of the barrier option, one is going to be picked out. I chose one with an intrinsic value when the barrier is hit, since they exhibit discontinuous payo and those are mostly used as a component of a structured derivative product. Because of the barrier option parity (in-out), the down-and-in put can easily been derived so that 2 out of 8 are covered here in this diplom thesis. A down-and-out put means that the option only exists if the underlying does not breach the barrier until the maturity, or stated dierently, the option ceases to exist if the barrier gets touch until the maturity. In the graph below it becomes clear, that the option price increases as the underlying decreases, analogues to the plain vanilla put option, but as the underlying gets closer to the barrier the option value decreases. When the barrier is touched the option value becomes 0 and the option ceases to exist.

21

t =0 t =0.5 t =1 Value downandout put 2.1534 Current asset price = 50 Value downandout put Strike price = 50 15 Barrier = 30 Black Scholes value function 10 Current Black Scholes value = 5.4011

0 30

40

50

60 Asset price

70

80

Pricing the barrier option with a tree causes some diculties. In the following example below, it will become clear what the problem is. The graph on the left shows a binomial tree with only one time step and a barrier, which does not get breached. In this case, the option price of the model equals the plain vanilla option price, valuated with the same method. The graph on the right shows a case with 5 time steps, where the barrier gets breached after the 4th time step. Since the model is discrete, it means that the asset price jumps from one node to the other, and breaching the barrier seems to cause a problem. This can be solved by placing the barrier on the node or rening the tree as suggested by adaptive mesh model when the underlying is trading close to the barrier.
Downandout put
75 120 110 100 90 60 80 70 60 50 40 40 30 20

Downandout put

70

65

Asset Price

55

50

45

35

30

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Asset Price

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Elapsed time

Elapsed time

22

Below, it will be shown how the option price evolves when the time partition is varied. As in the case of the plain vanilla option, the binomial and trinomial trees as well as MCS is considered. The trinomial tree will additionally get some modication suggested by Ritchken and Kamrad. FDM will not be tested. As for the plain vanilla option, the parameters are the following: S0 = 50, K = 50, r = 0.1, = 0.4 and T = 1. Stated in words: the option is ATM, time to maturity is one year, risk free rate is 10% and the volatility is 40%. Additionally, the barrier is set at 30 or in relative terms 60%. ) Binomial Tree Binomial tree does not seem to be an adequate method for pricing the barrier option. The deviation seems to be pretty persistent so that even after a big number of time steps, a descent result is not obtained (even after 250 time steps the deviation is bigger than 10%). The graph on the left again shows the deviation from the BS price in absolute values, whereas the graph on the right shows it in percentage. For the rst 10 time steps, the deviation from the BS price has not been reported, since the BS price for the barrier option is small and the deviation relatively huge.
8 7 6 3 5 2 4 1 3 2
1 2 3 4 5 6 7 8 9 10 15 20 25 30 35 40 45 50 60 70 80 90 100 120 140 160 180 200 250 300 350 400 450 500

6 5 4

8 7 6

35% 30% 25% 20%

5 15% 4 10% 3 2
100 120 140 160 180 200 250 300 350 400 450 500 10 15 20 25 30 35 40 45 50 60 70 80 90 1 2 3 4 5 6 7 8 9

0 -1

5% 0%

)Trinomial Tree It has been said in the theory part, that the trinomial tree is not an adequate method neither for pricing the barrier option since the convergence slows down dramatically when the barrier option is valuated. In the graphs below, obviously the trinomial tree does a better job compared to the binomial tree, but still, even after the time has been partitioned in 50 time steps the deviation is slightly above 10%.

23

4 3.5 3 2.5 2 1.5 1 0.5 0 1 2 3 4 5 6 7 8 9 10 15 20 25 30 40 50

2.5 2 1.5 1 0.5 0

4 3.5 3 2.5 2 1.5 1 0.5 0 2 3 4 5 6 7 8 9 10 15 20 25 30 40 50

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

In the theory, Kamrad and Ritchken came up with an additional parameter , which speeds up the convergence. They mention that the should be between 1 and 3. In the graphs below the (=1.15) has been chosen so that the average deviation from the BS price is minimized. It is obvious that with = 1.15 the convergence speeds up again. So, already after the time partition is bigger than 15 a deviation smaller than 10% is guaranteed.
7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 15 20 25 30 40 50 4 3.5 3 2.5 2 1.5 1 0.5 0 4 3.5 3 2.5 2 1.5 1 0.5 0 2 3 4 5 6 7 8 9 10 15 20 25 30 40 50 30% 20% 10% 0% 70% 60% 50% 40%

) Monte Carlo Simulation The MCS again, seems to do a very good job. The deviation from the BS price is throughout the entire graph below 10%. After 5000 generated asset price paths, the deviation less than 3% can be achieved.
2.35 2.3 2.25 2.2 2.15 2.1 2.05 2 1.95 1.9 250 750 1250 1750 2250 2750 3250 3750 4250 4750 -0.1 -0.15 0.1 0.05 0 -0.05 0.2 0.15 2.35 2.3 2.25 2.2 2.15 2.1 2.05 2 1.95 1.9 250 -1% 750 1250 1750 2250 2750 3250 3750 4250 4750 1% 3% 5% 7%

For the barrier option, the convergence and convergence speed will not be reported. It seems to be obvious that the trinomial tree here as well performs better than the binomial tree, which produces quite huge deviations. If the modication suggested by Ritchken and Kamrad is introduced, even a better result is obtained. The barrier option valuation with MCS should be preferred for pricing the barrier option. In the industry, among others, this is actually the way in which a barrier option is priced. 24

3.2

Empirical Part 2: How much do the IB shift the barrier?

In the previous part, it has been shown how the barrier option price valuated with numerical approaches converges to the BS option price. But is the BS price correct? The biggest drawback of the BS model nevertheless is that constant volatility is assumed. The volatility observed in the markets is anything but constant, which causes the closed analytical formula valuation to deviate strongly from the market prices. In this part, it will be shown that the BS price will overprice the market price strongly due to assumption of the constant volatility. Moreover, it will be shown how the IBs value the barrier options and to what extent they shift the barrier when they price the barrier options. Later, the consequences of this barrier shifting are examined. The following markets have been chosen as the underlyings for the option pricing: Swiss Market Index (SMI), UK Stock Market (FTSE), Standard & Poors 500 (SPX) and DJ Euro Stoxx 50 (SX5E). The general market view and the corresponding implied and realized volatility will here be briey reviewed.

3.2.1

Brief review of the markets

For the market analysis, the time period of the last 8 years has been chosen. This period contains both big stock market crashes, the Internet bubble and the Real Estate bubble in the US (but also in the UK). It is worth mentioning that the markets after 8 years have almost not changed at all compared to the initial value from the beginning of 2000. Even a couple of indices are below the initial level.
140 120 100 80 60 40 20 0 01.01.2000 01.05.2000 01.09.2000 01.01.2001 01.05.2001 01.09.2001 01.01.2002 01.05.2002 01.09.2002 01.01.2003 01.05.2003 01.09.2003 01.01.2004 01.05.2004 01.09.2004 01.01.2005 01.05.2005 01.09.2005 01.01.2006 01.05.2006 01.09.2006 01.01.2007 01.05.2007 01.09.2007 01.01.2008 01.05.2008

SMI Index

UKX Index

SPX Index

SX5E Index

25

Additionally to the general market view, the volatility will be reviewed here. The volatility serves as a risk measure and is from crucial importance for pricing the derivatives. In the graphs below, the implied and the realized volatility are reported. The implied volatility stems from an average of 3 calls, which are the closest to the ATM in terms of the moneyness. The maturity is 12 months for all of them. The realized volatility is calculated on 260 days basis, that means excluding the weekends. The dierence between the implied and the realized volatility is reported in form of the green column graph and indicates that the implied volatility is pretty much always higher than the realized. Selling the volatility seems to be a very attractive trading strategy (e.g going short a variance swap). The high implied volatility (relative to the realized) indicates as well that the options are more expensive than they should be, respectively, that the investors are too risk averse and buy too much protection. Regarding the implied volatility, it can generally be said that the volatility in 2007 increased a lot and recently came down again dramatically.
30

SMI
25

35 30 25

FTSE

12 10 8 6

20

4 20

15

2 15

4 2

10

0 10 0 -2 -4 22.09.2004 22.11.2004 22.01.2005 22.03.2005 22.05.2005 22.07.2005 22.09.2005 22.11.2005 22.01.2006 22.03.2006 22.05.2006 22.07.2006 22.09.2006 22.11.2006 22.01.2007 22.03.2007 22.05.2007 22.07.2007 22.09.2007 22.11.2007 22.01.2008 22.03.2008 12 10 8 20 6 6 4 2 0 5 -2 -4 22.09.2004 22.11.2004 22.01.2005 22.03.2005 22.05.2005 22.07.2005 22.09.2005 22.11.2005 22.01.2006 22.03.2006 22.05.2006 22.07.2006 22.09.2006 22.11.2006 22.01.2007 22.03.2007 22.05.2007 22.07.2007 22.09.2007 22.11.2007 22.01.2008 22.03.2008

-2

5 0

0 22.09.2004 22.11.2004 22.01.2005 22.03.2005 22.05.2005 22.07.2005 22.09.2005 22.11.2005 22.01.2006 22.03.2006 22.05.2006 22.07.2006 22.09.2006 22.11.2006 22.01.2007 22.03.2007 22.05.2007 22.07.2007 22.09.2007 22.11.2007 22.01.2008 22.03.2008

-4

imp.vol-realised 30

VOLATILITY_260D

12MO_CALL_IMP_VOL 12 10 8 30

imp.vol-realised

VOLATILITY_260D

12MO_CALL_IMP_VOL

SPX

SX5E

25

25

20

15 4 10 2 5 0 -2 22.09.2004 22.11.2004 22.01.2005 22.03.2005 22.05.2005 22.07.2005 22.09.2005 22.11.2005 22.01.2006 22.03.2006 22.05.2006 22.07.2006 22.09.2006 22.11.2006 22.01.2007 22.03.2007 22.05.2007 22.07.2007 22.09.2007 22.11.2007 22.01.2008 22.03.2008

15

10

imp.vol-realised

VOLATILITY_260D

12MO_CALL_IMP_VOL

imp.vol-realised

VOLATILITY_260D

12MO_CALL_IMP_VOL

3.2.2

Oer prices from the seven IBs

The barrier option is a derivative, which belongs to the class of the exotics. The exotics, generally, are traded over the counter and therefore their price is very dicult to obtain. For the purpose of comparing the BS model price with the market price, I have contacted few IBs and asked them for a pricing. 26

The prices received are indicative and not tradable. Seven companies provided prices for a down-and-out put option with the following characteristics: the option is ATM, barrier is set at 70%, time to maturity is 1 year and the underlying is one of the following: Swiss Market Index (SMI), Standard & Poors 500 (SPX), DJ Euro Stoxx 50 (SX5E) and FTSE (UKX). I thank the companies, which provided the prices and the parameter values included in the pricing. The companies are: JPMorgan5 , Goldman Sachs6 , UBS7 , CS8 , Deutsche Bank9 , Dresdner Kleinwort10 and Exane11 . The prices are oer prices, since the mid price would not contain any barrier shifting and would therefore not really be interesting here. Additionally to the barrier shifting, the oer price includes a certain amount of hedge costs, which is minor (approximately at about 10 bps) and can be neglected. As already shown in the theory part, there are 8 dierent barrier options. They can be divided in intrinsic and non-intrinsic barrier options. Only for the intrinsic barrier options a barrier shifting is needed. Why? The intrinsic barrier option has a certain value when the barrier is breached, that means that the option loses all the intrinsic value at some point, which causes the payo to be discontinuous. The discontinuity is actually the reason why a barrier bending is needed. This situation is especially observable, when the underlying trades close to the barrier and the time to maturity is a small. The barrier shifting is made so that the trader can react if the market all of a sudden breaks down and a sell o takes place. That means that down-and-out put is too expensive (the barrier is shifted to the left) and the down-and-in put is too cheap ceteris paribus. This is already a known fact and it will be discussed among others in the paper written by Schmock, Shreve and Wystup[10]. Several telephone calls with the brokers made it clear, that the barrier in this market circumstances is shifted between 2.5-3%, depending on the volatility skew level when the pricing is done. That means in this case here, that the shifting will be around the same for each index but dierent among
www.jpmorgan.com www.goldmansachs.com 7 www.ubs.com 8 www.credit-suisse.com 9 www.db.com 10 www.dresdnerkleinwort.com 11 www.exane.com
6 5

27

indices. The IBs, which provided the prices also provided the ATM volatility and the reference price of the underlying. For the sake of fairness the IBs will remain anonymous. In the graphs below the prices provided by the IBs are shown. The oer price is shown on the x axis and expressed in percentage of the spot price and on the y axis the ATM volatilities are shown.
24 23.5 23 22.5 22 21.5

SMI

24 23.5

SX5E

A
23

A F B E G

22.5 22

D E C G

21.5 21

21 20.5 20 2 2.2 2.4 2.6 2.8 3 3.2 3.4 3.6

20.5 20 2 2.2 2.4 2.6 2.8 3 3.2 3.4

24 23.5 23 22.5 22 21.5

SPX

24 23.5 23 22.5

FTSE

A F D E G C B

F D G

A
22

E B C

21.5 21 20.5 20

21 20.5 20 2 2.2 2.4 2.6

2.8

3.2

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

When the above presented graphs are observed, it can not be concluded that the higher ATM volatility causes the oer price to be higher. Actually, for the down-and-out put the volatility has two eects. On the one hand, the higher implied volatility increases the probability that the option ends ITM at expiry. On the other hand, the higher implied volatility increases the probability that the barrier will be breached and the option loses all the value. That means that the down-and-out put might be very insensitive to the absolute value of the implied volatility since the two eects might cancel out. What can be concluded is the aggressiveness of the pricing of each company. So for instance is the company F persistently the most aggressive one and company G the least aggressive one. In the graph for the SMI index, the company D could not provide a price for that underlying because they do not have a book for that underlying. In a rst step, the prices will be calculated with the BS analytical formula using the same input as the IBs provided additionally to the oer price. 28

Yet two parameters need to be estimated, risk free rate (r) and the dividend yield (q), which together are the forward basis (r q). This two parameters could not be obtained by the IBs, since they were included in the pricing by default according to the brokers. For the risk free rate, the 1y Libor in the corresponding currency has been used and for the dividend yield I used the estimate reported on Bloomberg.

3.2.3

The BS price overprice the market oer price strongly

As already mentioned above, the biggest drawback of the BS pricing model is the assumption about the volatility. The volatility is assumed to be constant, whereas the volatility is observed to be non constant in the market. Often the nancial instruments (especially the single stocks and the currencies) exhibit a smile, the index a skew. In the graphs reported below additionally to the oer prices from the IBs, the BS mid price is reported. Analyzing the BS price of the barrier option it becomes clear that the higher volatility causes the BS price to be be lower, or stated dierently, the eect that the barrier will be breached overweights, at least here, the eect that the option will end ITM. Graph below indicates that the BS price overprice the barrier options strictly and the overpricing is up to 100% compared to the market prices. Here, it could be argued that the oer price received by the IB is compared to the mid price obtained by the BS model, thus not really fair. Even if the BS oer price would have been plotted here, the eect would be marginal. The prices would shift parallel to the left and the situation would not have changed.

29

24 23.5 23 22.5 A 22 21.5 21 20.5 C 20 2 2.5 3 3.5 F B E

SMI

24 23.5 A 23 22.5 F D E C B

SX5E

BS-A

BS-A BS-F BS-B BS-E G BS-G BS-C

20 22 21.5 21 20.5

BS-F BS-D BS-E BS-G BS-C BS-B

4.5

5.5

2.5

3.5

4.5

24 23.5 23 22.5 22 21.5 G 21 20.5 20 2 2.5 3 3.5 C F D EB A

SPX

24 23.5 23 22.5 F BS-A BS-F BS-D BS-E BS-B BS-G BS-C 21.5 21 20.5 20 4 4.5 5 5.5 2 2.5 3 C 22 D E G A B

FTSE

BS-A BS-B BS-D BS-F BS-E BS-G BS-C

3.5

4.5

So, taking the barrier shifting into account for the BS model and choosing a barrier between 67-67.5% would not change a lot. The BS price would come closer to the oer market price but the deviation would still be huge.

3.2.4

How do the IBs price a Barrier Option

Why does the BS price deviate by such a big amount from the market price? The answer is the volatility. Because the BS model assumes a constant volatility, the skewness is not taken into account so that the ATM volatility is taken for the whole moneyness (St /K) of the option. And this is exactly the point, which makes the BS model strictly overprice the option. Through the volatility surface, the BS model underestimates on average the volatility, which then consequently results in a higher price.

30

The graph above shows the volatility as the function of the stock price and the time. The time axis can be neglected, at least then when the time to maturity is big. What is the driver of the down-and-out put option? Down-and-out put is very sensitive to the skew. The drivers of the down-and-out put price can be divided in two components: a long Gamma around the strike and short Gamma around the barrier. That means, that the slope of the Delta is positive around the strike (falling underlying will increase the price of the down-and-out put) and negative around the barrier (falling underlying will decrease the price of the down-and-out put). Because the barrier option can cease to exist at any point during the life time when the barrier is breached, the Gamma at the barrier is of American type, whereas the Gamma at the strike is of European type. The same holds for the Vega. So being long Vega at the strike means, that increasing volatility will increase the price of the option ceteris paribus. Being short Vega at the barrier means, the higher the volatility the more we would get for selling the option. Both together imply then that the steeper the skew (low volatility ATM and high volatility OTM), the cheaper the barrier option. So the Gamma and Vega of the American type at the barrier will dominate, thus determine the price. The Greeks will be further examined and portrayed in the application part 1. In the graph below the volatility skew is presented for all four underlyings, where the volatility is the function of the underlying. The graph exhibits, that the volatility increases as the underlying moves from ITM to OTM and that volatility decreases as the underlying gets deeper ITM. Stated dierently, the volatility tends to be higher on the downside. Observing the implied volatility for a single stock, the implied volatility increases even if the underlying moves from OTM to ITM, resulting in a so called volatility smile. 31

So far, it has been shown that the BS price overestimates the market price for the barrier options. Additionally, the forward basis (r q) needs to be estimated since every bank has an own system for estimating these two parameters. But estimation of these two parameters does not make the BS price to deviate strongly. It is the volatility, which is from crucial importance for an accurate pricing. On the one hand the IBs have again their own systems for estimating the volatilities and on the other hand their market view sometimes inuences the pricing. So e.g can an IB make a bet, which can not be modeled or the IB might prefer to close a open position, which they have on their books. Assuming that these kind of inuences do not occur, only the volatility impact will be from interest. How do the IBs price the barrier options? Contrary to the BS model, they take into account that the volatility is not constant. So for pricing the barrier options they include the whole volatility surface, the so called local volatility model, into their pricing model. Dupire [7] and [8] shows in his two papers how the pricing and hedging can be done when the volatility is not constant. More from a point of view of a practitioner, Overhaus et al.[9] show in their paper the link between the market and the corresponding volatility and how such a pricing will be done in the industry. Why does the whole volatility surface needs to be taken into account when a barrier option is priced? One reason is because the option might terminate at any time before the maturity. That means that the maturity of the barrier option can not be predicted for sure. For the down-and-out put option, the option ceases to exist as soon as the barrier is breached. If the barrier is not breached through the whole life time of the option, then the maturity equals the predicted maturity. For a plain vanilla option this is not the case. The 32

maturity is known so that only the volatility with a certain time to maturity needs to be accounted for in that pricing. The second and the much more important reason is that the volatility is stochastic itself. That means that the stock price follows a stochastic process, and the volatility, which is part of this stochastic process is again a stochastic process for itself!

As above mentioned, an intrinsic barrier is very dicult to hedge. This compels the IB to shift the barrier to the left when they price the down-and-out put option. That means that the mid price will be at the true barrier (70%) and the oer price at a barrier further to the left. The most brokers, who provided the prices mentioned that the barrier shifting is depended on the volatility level and volatility skew. That means that the higher the current volatility and the skew are, the higher the shift will be. At the moment the barrier is shifted between 2.5-3%. But what does that mean in terms of the oer price compared to the mid price? How much more expensive will the down-and-out put be?

3.2.5

What does it mean when the Barrier is shifted 2.5-3%?

In graphs below it is shown how the down-and-out put price will change as a function of the barrier shifting. The used model here is the local volatility model, which takes the whole volatility surface as a pricing parameter. The graph on the left shows how the price evolves from a starting point 0, which represents the true barrier of 70%. The barrier shifting up to 4.5% is then shown with a barrier shifting step of 50 bps. The barrier seems to inuence the option price positively, as expected, that means, that the more the barrier is shifted to the left the higher the price of the down-and-out put will be. 33

The graph on the left shows how the price of the barrier option changes in percent, where again the true barrier of 70% represents the starting point. The result is very surprising! The barrier shifting of 2.5-3% results in an more expensive down-and-out put option oer compared to the mid. The agio is up to more than 22%!! From the both graphs, it is obvious that the SMI has the smallest volatility and therefore the highest prices on one hand, and on the other hand, the same underlying will be aected the least from a barrier shifting. The FTSE has the highest volatility and therefore the smallest prices, but will be aected by the barrier shifting the most. Here, it can be assumed, that the volatility skew (110/90) has the same slope for all of them.
40.00% 4.00% 35.00% 3.50% 30.00% 3.00% 25.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 0 0.005 0.01 0.015 0.02 SMI 0.025 UKX 0.03 SPX 0.035 SX5E 0.04 0.045 0.05 20.00%

15.00%

10.00%

5.00%

0.00% 0 0.005 0.01 0.015 0.02 SMI 0.025 UKX 0.03 SPX 0.035 SX5E 0.04 0.045 0.05

The nding above was quite impressive. In the graphs below it is examined how the barrier option prices evolve for barriers ranging from 95% to 10%. The graph on the left shows, pretty intuitively, that the lower the barrier is the higher the option price is. The barrier option converges to the BS price as the barrier converges to 0. The lower the volatility the higher the convergence to the BS price since a lower volatility makes the barrier option more expensive c.p. and therefore closer to the BS price. Here, again, the skew of all them is around the same. In the graph on the right it is shown how the price changes evolve compared to the previous barrier. So e.g the price change in percent is the highest when the barrier is moved from 65% to 60%. This means that shifting the barrier in this area results in the highest increase of the price.

34

9.00% 8.00%

1.20%

1.00% 7.00% 6.00% 5.00% 0.60% 4.00% 3.00% 2.00% 0.20% 1.00% 0.00% 0 0.1 0.2 0.3 SMI 0.4 0.5 FTSE 0.6 SPX 0.7 SX5E 0.8 0.9 1 0.00% 0 0.1 0.2 0.3 SMI 0.4 FTSE 0.5 SPX 0.6 0.7 SX5E 0.8 0.9 1 0.40% 0.80%

3.2.6

Barrier Option valuation, revisited

So far, it has been shown that the BS model strictly overprice the barrier option. It has only been shown how big the overpricing is only for a certain barrier level (70%). In this part, and as the end of this section, the examination is done for a barrier option with a range of dierent barriers and then compared to the corresponding BS price. In the graph below such an examination is done for the SMI index. The barrier option price valued with the BS model does not overestimate strongly the barrier option price valued with the local volatility model for both, the vary high barriers and very low barriers. The overpricing is the biggest in between, being more concrete, at the barrier at around 70%.
8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00% 0 0.2 0.4

BS Barrier Option (LN)

0.6
Local volatility model

0.8
Difference

1.2

3.2.7

Trinomial Tree, revisited

In the empirical part 1, it has been shown that the trinomial tree gives quite a good approximation for the barrier option, especially when the Kamrad 35

and Ritchken [16] modication is included in the model. In the empirical part 2, it has been shown that the volatility is not constant and that the BS model strictly overprice the barrier option. Therefore, for an accurate pricing rather the whole volatility surface should be considered than only one certain volatility point. Derman, Kani and Chriss[6] show how a trinomial tree can be constructed with relaxing the assumption about constant volatility. They chose the trinomial tree because of the additional parameters, which they use for the state space, just to mention one of the most important. This subsection is not meant to go into detail, rather to provide a connection between the empirical part 1 and 2. The graph below shows the comparison between two trinomial trees, the one on the left assuming constant volatility and the one on the right relaxing this assumption.

Application Part

In the empirical part it has been shown that due to hedging diculties the intrinsic barrier option needs some barrier adjustment when such an exotic option is priced. In the application part 1, a structured product (SP) containing such a barrier option as component is developed and priced. Since a private client can not buy solely the down-and-out put option (of course the very big private clients are excluded) a SP, the bonus certicate, is here therefore introduced. After the introduction of the product, the view of the client, the IB and the asset manager is examined. In the application part 2, the focus will be on the pricing of the structured products. More concretely, the question if the SP are fairly priced for the Swiss market is answered. Similar empirical investigation to the one given by Wilkens, Erner and Rder[5] and Stoimenov and Wilkens[4] for the German o 36

market is going to be done for the Swiss market, but some modications are allowed.

4.1

Application Part 1: Bonus Certicate

Bonus Certicate is a SP with the following payo:

Bonus Ceritficate
160 140 120 100 p&l 80 60 40 20 0 0 20 40 60 80 price underlying barrier not breached barrier breached 100 120 140 160

The components creating this payo are: - long the underlying - long the down-and-out put The specialty of this product is, that the long down-and-out put is nanced by the withheld dividend. Therefore, the underlyings with a high dividend seem to qualify as good candidates for such a product, because either more of the down-and-out put can be bought or the barrier can be shifted further to the left. Another important factor is, as shown above, the volatility or rather the volatility skew. Since the screening for the volatility skew is very dicult and time consuming, here it has been assumed that the higher volatility causes the volatility skew to steepen, thus makes the barrier option more attractive. This assumption is quite realistic, since no member of the SMI index has a persistently high volatility level. So for instance, in 37

volatile markets, the investors tend to buy protection (put), therefore the price of the option will increase, hence the implied volatility will do. Additionally, to enhance their returns, the investor will prefer to sell OTM calls, which will further cause the volatility skew to steepen. In the graph below these two important parameters, dividend and volatility, are plotted for all of the SMI Index members. The stocks on the top-right have both, the high volatility and the high estimated yield. It is not surprising, that these stocks are very often encountered in this product type.
50
CLN

SMI Members
VX Equity UBSN VX Equity

45 40

CFR

VX Equity NOBN VX Equity VX Equity ADEN VX Equity VX Equity HOLN NOVN BALN VX Equity SCMN VX Equity VX Equity CSGN VX Equity VX Equity RUKN ZURN VX Equity VX Equity

35 hist_call_imp_vol 30
SLHN

ABBN BAER VXVX Equity Equity SYNN UHR

25 20 15 10

VX Equity

ROG

VX Equity

SYST

VX Equity NESN VX Equity

5 0 0 1 2 3 4 5 6 7

dividend yield indication

4.1.1

From clients point of view

The payo structure of the bonus certicate is very popular in the SP world. But, why should a client buy such a product? One benet for the client buying this product structure, equivalent to buying the underlying and the barrier option, are the transaction costs. For buying a package, only one transaction is needed, whereas constructing such a structure on its own needs two transactions. Additional benet is the access to the exotic markets. A private client does not have the access to the OTC markets, thus can not buy a down-and-out put option. And the last benet mentioned in this context is the denomination: the client can enter such a market with a quite a small amount of money (in Switzerland already with 1000 CHF). A better reason to buy a down-and-out put is the possibility to trade the skew. It has been mentioned above, that the down-and-out put is very sensitive to the skew. Stated dierently, buying a down-and-out put means buying the skew. So if the skew attens, the barrier option would become less expensive ceteris paribus. Thus, the down-and-out put could be used as a vehicle to trade the 38

skew. In the graph[15] below it is shown, how the prices will change when the skew reduces. Four down-and-out puts with dierent barriers and one plain vanilla put are plotted. It is clear, that the skew reduction will have the biggest impact on the down-and-out put with the smallest barrier (80%). The skew reduction of 4% will there almost halve the initial price.

The above mentioned arguments give some reason why an investor should buy such a structure. There are more important reasons why an investor should not invest in such a product. Bradbury[22] shows in her diplom thesis that the investors systematically underestimate the risks involved in a down-andout barrier products, which explains why this product structure has gained such a popularity in the recent years. That means that the investors do not really realize what kind of risk they go into when they buy such a product. Rieger[23] shows how a SP with the same payo could be created. This product would be much easier to hedge, this means that the IBs would not have to shift the barrier when pricing such a product, which then would not have any overpricing as shown above. But, such a product does not exist! Hens and Rieger[3] show in their paper that the most structured products are not optimal for a perfectly rational investor. Additionally to the mis-estimation, they report the heterogeneous beliefs. The heterogeneous belief indicates that the market will behave dierently than the probability distribution p forecasts (often a sign of overcondence). More, they show that such a barrier product is not optimal for any decision model and only the mis-estimation (the investor tend to underestimate the probability that the barrier is breached) can explain their popularity. The heterogeneous beliefs can explain it partly, if even. To buy such a structure does not seem to be very attractive from the 39

clients point of view. But, there is very high demand for products with such a structure. Here, as the last point of this subsection, it is shown that adding the derivatives to a portfolio can result in a higher utility function. For this study, the S&P 500 and BXM[25] indices have been used. The latter has been launched by the options exchange CBOE and is basically an overlay strategy on the S&P 500 index, or stated dierently, a covered call strategy. That means, that the BXM Index is selling monthly slightly OTM calls on the S&P 500. Therefore the BXM Index is going to outperform in sideways and bearish markets, whereas S&P 500 is going to outperform in strong bullish markets. Both are presented below.
700 600 500 400 300 200 100 0 Jan 90 Jan 91 Jan 92 Jan 93

Peformance of SPX and BXM

Jan 94

Jan 95

Jan 96

Jan 97

Jan 98

Jan 99

Jan 00

Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Jan 06

Jan 07

spx index

bxm index

A good starting point for the explanation is the normal distribution function, which is presented below (X (0, 1)). It is a very common assumption in the nancial industry to assume that the prices are log normally distributed and the returns therefore normally distributed. A more realistic way to model the returns would be to allow the existence of the fat tails. The fat tails imply that the more extreme events, positive and negative, occur more often than predicted by the normal distribution, which increases the variance, therefore the volatility. And this is actually what is happening with the overlay strategy. The form of the distribution will slightly be amended and shifted to the right. The fat tails will be reduced and the distribution will become skinnier. In terms of the mean and variance, the mean will increase and the variance will decrease. In the world of the CAPM, the investors will choose the asset with the lowest volatility and highest expected return. So, in the world of CAPM, the investor will prefer the BXM index over SPX index! The above given benets of an overlay strategy will be proven below.

40

Jan 08

1.20

1.00

0.80

0.60

0.40

0.20

0.00 -5 -4 -3 -2 -1 0 1 2 3 4 5

Here, the distribution of the monthly returns of both indices from 1990 till today are shown. Both graphs exhibit what has been stated above. The SPX index has much stronger tails and fatter shoulders. The BXM on the other side has much skinnier shoulders and atter tails. The expected return of the SPX (BXM) is 0.66% (0.86%) and the standard deviation is 3.95% (2.70%). So the BXM has higher expected return and lower variance. Its distribution is slightly shifted to the right and the variance is slightly reduced as shown in the graphs below. The graph on the right shows both distribution together (normalized).
70 60 50
0.8

SPX

1.2

70 60

BXM

1.2
80

50

70

50
0.8

30

60

40
0.6

40
0.6

50 10

30
0.4

30
0.4

40

-10

20 10 0
0.000 0.027 0.053 0.079 -0.158 -0.131 -0.105 -0.079 -0.052 -0.026 0.106
0.2

20 10 0
0.013 0.033 0.053 -0.126 -0.106 -0.086 -0.066 -0.046 -0.026 -0.006 0.073
0.2

30

-30

20

-50

10

-70

In terms of the utility function, two dierent models, expected utility theory (EUT) and prospect theory (PT) are qualitatively presented. It is going to be shown that for both the overlay strategy increases the expected utility. First, the EUT is examined. In the graphs below the utility function is plotted. The utility of money is concave and the marginal utility is decreasing as the money increases (lim f (k) ), lim f (k) 0). The graph on the left shows the case, where only the variance has been reduced ceteris paribus. Due to lower variance, the dispersion is reduced and therefore the expected 41
k0 k

utility increased. In the graph on the right, the case is shown where the expected return has been increased ceteris paribus. Due to higher expected return, again a higher expected utility can be obtained. Both combined result in a even better case for the investor, which an overlay strategy can provide.
Variance Reduction
Exp. Return Increase

Last, the PT is examined. There, the gains are assumed to be concave and the losses convex. More, rather a reference point and not the nal wealth is relevant, which lies where the both axes cross. So, the gains will be to the right of the reference point and the losses to the left. In the graph below the corresponding utility function has been plotted. We see, that the investor prefers ofter a smaller gain than once a high gain. In contrast, due to convexity in the losses, the investor prefers a high loss once rather than ofter few smaller losses. And this is actually what the BXM index oers. The graph on the right shows the dierence of the frequencies of occurrences of a certain return. So for instance, the overlay strategy oers both, a higher frequency of relatively small returns and lower frequency of relatively low returns.

42

35 30 25 20 15 10 5 0 -5 -10 -15
-0.158 -0.131 -0.105 -0.079

BXM-SPX

-0.052

-0.026

0.000

0.027

0.053

0.079

In both, EUT and PT respectively, the overlay strategy seems to be a strictly dominate strategy. The overlay has been done here with plain vanilla option. But how does the situation change when the barrier option is sold instead of the plain vanilla option? Let assume that the up-and-out call is sold. The situation does not change very much. The premium will be indeed smaller but the upside would not been capped. Further study is not done here. 4.1.2 From IBs point of view

It has been shown above that from the clients point of view, an investment in a bonus certicate does not really seem to make sense. From the IBs point of view, the whole situation looks completely dierently. It has already been mentioned above, that such a product is very dicult to hedge and that a barrier shifting is needed. That means, that such a product will consequently be more expensive. Additionally to the value after the barrier bending, lets call it fair value, there need to be be added up the IB margin (CVA: Client Value Added), the private bank margin (UF: Upfront) and the hedge costs(HC).
0 Price=Offer

Fair CVA UF Hedge Cost Value

So from the IBs point view, the sales and the trading are involved in the issue process of the product and both divisions make money. So for instance, if the market is breaking down and the product is coming close to the barrier, the IB often calls up the client and tries to unwind the position. Therefore 43

0.106

such a barrier shifting would not be of need in the rst place, if the client and the IB could agree in the beginning to unwind the position in such a case. At this point it has to be said that the market (primary) is quite competitive when it comes to pricing a product. The private bank starts a competition and the IB with the best oer gets the deal. (For big banks, such as UBS & Credit Suisse in Switzerland, their own IB is preferred if the price is not very far away from the best oer.) Such a case is vary similar to the Bertrand Monopoly, where already two competitors are sucient to make the market look like perfect. So when an IB loses a competition, they always ask for a feedback so that they know how far away they are from the best oer, so that they can adjust their pricing parameters and price the next competition more aggressively. In the secondary market, the situation looks dierently for the IB, which now acts as a monopoly. The private bank, the investment bank and hedge cost margin will be amortized over short period of time and the fair value of the product will be moved in between the bid and ask, which means that IB will make money on the gap spread.
Bid Ask

Fair Value

At the maturity of the product, the IB often places the fair value at the bid price so that the product price equals the fair value in case that the product is bought back by the IB. So, it is to expect that the price of the SP will deviate from the fair value the most at the issue date. At the end of this subsection it is shown how the IB could hedge such a position. It will be shown, that such a position is dicult to hedge and that the barrier shifting is justied. One way, the most obvious one, of hedging the position is to try to buy the down-and-out put, since the IB is short when such a SP is issued. An other way to hedge such a position would be to create a portfolio consisting of the following instruments long put short American digital option short down-and-in call 44

or more formally, pdao = p cdai Digitalamerican . So if the barrier is not hit, then the down-and-out put is equal to the long put and the hedge works perfectly, since neither of the two exotic options kick in. If the barrier is hit, the down-and-out put loses all the intrinsic value at that point. The American digital option kicks in and has the same value as the barrier options at that point and accounts for that loss in intrinsic value. The down-andin call kicks in and has the same time value as the long put. The whole portfolio is then sold. But the problem of hedging is not really solved, since the American digital option again exhibits discontinuity (This will be shown below in detail). What additionally needs to be solved is the down-and-in call option, which is classied as the non-intrinsic barrier option, which knocks in without being ITM. The hedge hear is again not very straight forward: Long put and short the underlying is the portfolio needed in this case. So if the barrier is not breached the down-and-in call does not knock in, the put expires without any value and the short underlying corresponds to the down-and-out call, obtained by the in-out parity. This on the other hand means, that the down-and-out call is hedged by the buying the underlying and charging S0 K when down-and-out call is sold. The graphs are taken from an internal paper written by Allen, Einchcomb and Granger[15]. They clarify the hedge mentioned above. On the left, the hedge for a down-andout call is presented, and on the right the hedge for a down-and-in call is presented. It has to be said at this point that the hedge for the down-and-out call demonstrated so far is too trivial. A more realistic hedge is presented further below.

A more appropriate way to hedge the down-and-out call (the IB is short) is done by a risk reversal, long (OTM) call and short (OTM) put. The barrier value equals the ATM of the underlying. So if the underlying never breaches the barrier, the long call accounts for the down-and-out call and the put expires worthless. When the barrier is hit, the risk reversal will be sold. The short put is needed to cancel out the long theta by being long the call. So, 45

the call will account for the intrinsic value and the put for the time value. This shows again that the volatility skew is very important pricing driver for a barrier option. Now, back to the American Digital, which again has an discontinuous payo. The American digital option can be hedged by the increasingly tight call spread, that means a call (ITM) is bought and a call (OTM) is sold. Comparing the American digital to the European one, the rst will be twice the second, assuming zero drift and zero skew. The intuition is the following: for the European digital only the maturity is relevant for the payo, whereas for the American digital the whole lifetime of the exotic. So once the barrier is touched, there is an even chance that the underlying will be above or below this barrier, or stated dierently the European digital will end up not below 1 the barrier with a probability of p = 2 . So neglecting the theta, the downand-out put will be priced as a portfolio, with being long put and short twice the European Digital. The description above shows that the barrier options (intrinsic ones) are dicult to hedge and the barrier shifting seems to provide an appropriate solution from the perspective of the IB. 4.1.3 From Asset Managers point of view

Approaching the SP from the CAPM, Capital Asset Pricing Model, or stated dierently, assigning them a place in that framework, is not possible. In the framework of Two-Fund-Separation, there is no space for SP, since it is only optimal to hold the market portfolio (or a friction of it) and the risk free rate. So what is the reason for the asset manager to include such a structure in the portfolio or using the down-and-out put as a portfolio hedge? In Switzerland the overlay strategy is very popular in terms of generating additional returns. That means that the asset manager tends to buy the asset and sell an OTM call on that asset, which is very often a single stock. On the other hand, the asset manager hedges the portfolio by being long the put. From the supply and demand perspective, their is an excess supply on the call side and an excess demand on the put side. The excess demand on the put side makes the put more expensive. It has been said several times, that the barrier down-and-out put is much cheaper than the corresponding plain vanilla put in terms of costs. That means that a down-and-out put can be used as a hedge by an asset manager, but the market view has to 46

match with the downside protection of the barrier option! The down-and-out put should not be used only because a cheaper hedge is obtained, because the hedge disappears once certain threshold is touched. So far, the barrier option as a hedge has been considered. Now the question regarding whether it makes sense to include a SP with such a structure is briey mentioned. The barrier option is taxed in dierent way than the plain vanilla put since it does not really provide a hedge as the latter. Therefore from the perspective of taxes such a product might be preferred by the client ant therefore as well by the asset manager. Wild [24] discusses several SPs and corresponding taxes implication in his diplom thesis. Regarding the SP with such a structure, there are several hidden risks, which need to be studied thoroughly. David Ruppert mentions in his book a negative correlation between the prices and the volatility, which means that the falling prices and increasing volatility move along with quite strong empirical evidence. The graphs below shows the regression of the SPX and the corresponding volatility index, the VIX. The correlation between them is 0.06.

That means that the volatility will increase as the market falls. The graph below12 shows a Bonus Certicate. On the left the volatility is assumed to be constant, and on the right the volatility increases as the market falls down. The graph on the right assumes a minimum volatility of 10%, which is persistent even if the market is extreme bullish. With this assumption it is avoided that the volatility falls to an implausible level, which is certainly above the level assumed here. Both graphs show the scenarios at dierent time to maturities. It becomes clear that the smaller the time to maturity is, the closer the payo is to the nal payo, which is labeled with the green line. So, concluding the stated above, it can be said, that the barrier option loses the protection when it is needed the most, that means, when the volatility is
12 The graphs have been generated with the application Fincad. The explanation regarding the application can be found on the web page: www.ncad.com

47

very high.
12000

12000
11000

11000
10000

10000
9000

9000
Portfolio 8000

Portfolio
60.0% 70.0%
24.06.2008

8000

7000

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80.0%

90.0% 100.0% 110.0% 120.0% 130.0% 140.0% 150.0% Underlying Level

24.10.2008 24.12.2008 24.02.2009 24.04.2009

4000 50.0%

60.0%

70.0%
24.06.2008

80.0%

90.0% 100.0% 110.0% 120.0% 130.0% 140.0% 150.0% Underlying Level

24.10.2008 24.12.2008 24.02.2009 24.04.2009

24.04.2008

24.08.2008

24.04.2008

24.08.2008

An other point which the asset manager should be aware of are the Greeks and their dynamics when a barrier option, or a SP containing such an exotic, is considered. The Greeks represent the sensitivities of the derivative and are from crucial importance for the investment bankers as well as for the asset managers when they manage their positions. So for instance just to mention the most used and applied: = = =
f t f S S f

V ega =

Generally speaking, the asset manager manages a portfolio with several positions. The Delta of each position within the portfolio shows the market exposure and the mark-to-market risk of each single position. Special attention should be given to the Delta exposure, which shows how the derivative changes when the underlying changes. In terms of the exposure, it shows how much of the underlying needs to be bought so that the a Delta neutral position is obtained. An other Greek, which is here examined is the Vega. It shows how the underlying will change when the volatility changes. First, let here assume that a Bonus Certicate, and therefore a down-and-out put 48

(long), is a part of such a managed portfolio. The below shown example is a down-and-out put option on UBS, ATM (25), barrier is set to be 20, time to maturity is 89 days, the barrier is observed on a continuous basis. All the graphs show the scenarios very close to the maturity. The graphs below from left to the right are Delta, Gamma and Vega (in percent).

Lets start the explanation when the underlying is ATM and moves towards the barrier. Delta is negative, the usual situation encountered as for the plain vanilla put. But as the underlying moves towards the barrier, the Delta switches from negative to positive. That means that an increasing price would increase the value of the down-and-out put, which is now dierent to the plain vanilla put. When the underlying is very close to the barrier and the time to maturity is very small, then the value of the Delta literately explodes and becomes very big. Since Gamma is the second derivative, the situation is very similar to the one described above for Delta. The scenario indicates that such a situation within the portfolio will imply that the Delta exposure of the whole portfolio will be very misleading. The situation for the volatility change is again dierent to the one of the plain vanilla option. Again the situation is considered when the underlying moves from ATM to the barrier. The Vega is positive, the same as for the plain vanilla put. Higher volatility makes the option more expensive. But here again, the sign switches at some point. As the underlying moves to the barrier, the volatility increases since the negative correlation between them exists. When the underlying is close to the barrier, the high volatility increases the probability that the barrier is hit and the option knocked out. Therefore the Vega is the lowest the closer the underlying to the barrier and the time to maturity very small.

49

4.2
4.2.1

Application Part 2: Are SP fairly priced?

Introduction

In this part it is going to be examined if the conclusions, at least some of them, made by Wilkens, Erner and Rder[5] and Stoimenov and Wilkens[4] o hold for the Swiss market. That means that the most products will contain Swiss single stock underlyings, but not exclusively. [5] examined the German Market for the reverse convertible (RC) and discount certicate (DC) for one month in 2001. The three researchers found out a strong pricing bias favoring the product seller for both, the RC and DC. [4] examined the German market for equity-linked structured product (EL), a more general study. EL can be divided in two groups, the group containing the plain vanilla option component (classic, corridor, guarantee, turbo products) and the group containing the exotic option component (knock-in, knock-out products). In their paper the two researchers postulate three hypothesis, where only the rst two are mentioned here: In the primary market, equity-linked structured products are priced, on average, above their theoretical values. (H2) The overpricing is higher a) for products with stock underlyings than for those with index underlyings and b) for more complex products, compared to classic instruments. Speaking of the complex products, the products having the barrier option as a component are meant. In their summary the two researchers conclude that products with an embedded exotic option are subject to even higher premiums, compared to the common classic products. They as well mention that this overpricing is due to higher hedging costs, which is as shown above somehow justied. In this part it will be shown if the above proven facts for the German market hold as well for the Swiss market. Due to limited capacity, time restriction and the subject of this diplom thesis, the analysis will be concentrated on the RC, DC, barrier reverse convertible (BRC) and bonus certicate (BC). (H1)

50

4.2.2

Methods

The pricing for the SP containing the plain vanilla option (RC, DC) will be done by a pricing function available on bloomberg, which uses the BS model. The tool on bloomberg delivers automatically all the input parameters needed, such as volatility, estimated dividend and risk free rate. As already mentioned above, the BS model provides a very accurate price for the plain vanilla option and is widely applied in the industry. All the parameters included in the pricing will be the closing level on the date when the product has been issued. For the latter two SPs containing the barrier option, a local volatility model will be applied for their pricing. There, the problem is that the tool, which applies the local volatility model can not construct the volatility surface from the past, so that the product containing the barrier option has been priced a couple of days after it has been issued. The issue date time frame will be the whole year 2008 so far, where the products issued recently (in June 2008) will be preferred (especially for the BC and BRC). The products are picked randomly from the two, [33] and [34], online platforms. Thirty products will be priced, twenty of them containing the plain vanilla option (RC and DC, each ten) and ten of them containing the barrier options (BC and BRC, each ve). What can be expected regarding the deviation from the market price to the fair value? It is to expect that RC and DC will slightly, if even, overshoot the fair price ((H1) will be rejected). (H1) postulated above will be rejected in terms of, that the overshooting, if anything, will be very small so that such a product can be obtained cheaper than buying the two structures separately. Especially, the strong bias favoring the seller found by Wilkens, Erner and Rder[5] will be rejected. The product containing a plain vanilla option is o quite transparent. The price of the plain vanilla option component can not deviate strongly from the plain vanilla option traded on the exchange. So stated dierently, if the SPs containing the plain vanilla options are over priced, then it could be argued that the plain vanilla options traded on the exchanges are overpriced as well. The products containing the barrier option are expected to have a stronger overshooting ((H2) will be conrmed). Even though the two researchers use a wrong model (not the local volatility model) to price a barrier option, their hypothesis will be conrmed due to barrier shifting, which makes the barrier option more expensive. The barrier shifting is of course the major driver of 51

the higher premium. An other important driver, which has to be mentioned at this place is the liquidity. On the one hand, the barrier options are traded OTC, therefore not very liquid, and on the other hand the liquidity of the underlying is very important. Several brokers mentioned as well in this context, that the quotient of the notional amount and the liquidity could represent the hedging speed. That means, in an extreme case, a very high notional amount and low liquidity of the underlying would result in a extraordinary premium, due the fact that the notional amount to be hedged is high and the hedging due the liquidity restrictions dicult. Both studies have been done in 2003 and 2005 respectively. In does not seem to be very far away, but it is. The market became more and more competitive in the recent years so that too high premiums would not have been sustainable. Basic economic theory predicts that such an arbitrage would have been removed by the market participant and this is especially what is expected to have happened. Both studies examine the primary and the secondary market. Here the focus will be on the primary market, since the biggest deviation occurs at the issue date. In both papers, [5] and [4], the researchers try to duplicate the pay o of the SP. In one of the papers[5], they use for their duplication portfolio the options traded on the Eurex (European Exchange), where their try to minimize the dierences in both, the strike and the time to maturity. Since the biggest deviation occurs at the issue date, the focus will lie on the issue date. In the other paper[4], they duplicate the SP by calculating the theoretical value of the SP. For the SP with the barrier option as a component, they use the formulas given by Rubinstein and Reiner[18], which does not use the local volatility model. And this is actually what has been shown above, wrong! The closed analytical formula is not taking the whole volatility surface into account, thus overpricing the market price of the exotic option signicantly. Hence, the SP will be overpriced as well. Before the results are presented the products priced are briey reviewed. They are all together somehow connected. To see the link, a good starting point is the Put-Call parity, which is KerT + c = p + S0 . With some basic algebra the equation below can be rewritten into S0 c = KerT p 52

where the left hand side is the DC (long the underlying, short the call) and the right hand side the RC (long the zero bond, short the put). Since the left hand side is equal to the right hand side, both products have exactly the same pay o. The taxation is dierent and is reviewed in detail by Wild [24] in his Diplomarbeit. When the plain vanilla put on the right hand side is replaced by the in-out parity (ppv = pdao + pdai ) and after one rearrangement the BRC is created. (For the sake of completeness, the left hand side is the barrier discount certicate, which will not be examined here). S0 c + pdao = KerT pdai For the BC, the call needs to be moved to the other side so that following equation evolves: BC = S0 + pdao = c + KerT pdai = c + BRC 4.2.3 Results

Here, the results obtained will be presented. First, the results for products, which have a plain vanilla option as a component will be presented, that means DC and RC. Later, the results for products, which contain a barrier option as a component will be presented, that means BRC and BC. a) Discount Certicate and Reverse Convertible Note The DC is a certicate, where a stock is oered at a certain discount. The discount is possible because a call option is sold and the resulting cash ow can be used to buy the underlying. Normally, if the stock closes above the strike then a cash settlement takes place, otherwise the certicate holder gets the underlying stock at a predened discount. The IBs price such a structure with a call spread, that means a call is sold, normally ATM or slightly OTM, and a call is bought being deeply ITM (Delta close to one). The latter will be achieved by being long a LEPO (Low Exercise Price Option). Such a option has the same payo as a forward or the stock itself, since the volatility and time value (Vega and theta are close to zero) do not inuence the price of that option. The RC is a note, where a zero coupon bond is bough and put, normally ATM, is sold. The reverse convertible has the same payo as the DC, but it should be mentioned again, that the both are taxed in a dierent way. Since the option value is positively inuenced by the volatility, especially in 53

the high volatility regimes, high coupons, respectively high discounts can be achieved for both products. As already mentioned, both structures have been priced on bloomberg since they both contain plain vanilla options as a building component. For the DC, a two leg - 2 plain vanilla options - have been priced13 . For the RC, there is a bloomberg14 function, which allows a direct pricing of such a structure. The results of this subsection can be summarized as follows: Both structures are quite fairly priced. The overshooting is as expected very low. From the investorss perspective, both products can be obtained cheaper than buying corresponding components separately. Although the price at the issue is higher than the fair value, the overshooting is smaller than 1% (on average) for single stocks. Therefore, the founding of both, [5] and [4], will be rejected for the SP with plain vanilla options as a component of that product. The brokers as well mentioned here, that for these products the market is very competitive and that on average one Vega for single stocks and 0.5 Vega for indices can be charged when options are priced. Stated dierently, there will be a bid-ask spread on the volatility when such a product is issued. Therefore, it can be argued that the plain vanilla options are as well overpriced since there as well a spread is charged. Below the results for the DC are presented. In the rst table the discount has been deducted from the issue price. This price has then been compared to the fair value price. The normal case is that the fair value price lies under the oer price and therefore the discount oered is smaller than it could have been oered. But, there are products for which this fair value price actually lies above the price oered by the IBs, which indicates that the SPs (A and E) are actually under priced! This discount which could have been oered is then shown in the last column of the table. The one product for which the deviation is huge is a DC traded in a dierent currency than the underlying itself. These kind of products are called Quanto. That means that for such a product additionally a Swap needs to be entered. But the deviation is still to big and a wrong data input might be suspected.
13 14

For purposes of recalculation: the bloomberg function is OVME For purposes of recalculation: the bloomberg function is OVSN

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name A B C D E F G H I J

discount(d) price(p) (p) (d) pricef v(pf v ) discountf v(df v ) 14.12 100 85.88 86.21 13.79 13.71 100 86.29 86.10 13.90 12.20 100 87.80 87.41 12.59 16.78 100 83.22 82.49 17.51 11.27 100 88.73 89.29 10.71 10.46 100 89.54 85.42 14.58 13.00 100 87.00 86.21 13.79 9.31 100 90.69 90.32 9.68 7.38 100 92.62 90.85 9.15 22.80 100 77.20 77.09 22.91

In the table below additionally to the oer price and the fair value price, the fair value price with the volatility spread is shown. There one Vega percent point spread has been added. That means, that the volatility is reduced by 1% since a call is a sold, therefore the discount obtained is reduced. The last two column indicate the deviation from the fair value price (deviation 1) and the deviation from the fair value price including the volatility spread (deviation 2). The average deviation 1 is 0.76% points and average deviation 2 is 0.41% points. Excluding the outlier F the deviation 1 is 0.39% points and deviation 2 is 0.02% points. When the volatility spread has been added already 4 products seem to be under priced, which indicates that even less than 1% point is charged. name A B C D E F G H I J (p) (d) pricef v 85.88 86.21 86.29 86.10 87.80 87.41 83.22 82.49 88.73 89.29 89.54 85.42 87.00 86.21 90.69 90.32 92.62 90.85 77.20 77.09 pricef vinc.vol.spread 86.60 86.48 87.78 82.78 89.68 85.64 86.62 90.72 91.13 77.39 deviation1 deviation2 -0.33 -0.72 0.19 - 0.19 0.39 0.02 0.73 0.35 -0.56 -0.95 4.12 3.90 0.79 0.38 0.37 -0.02 1.77 1.49 0.11 -0.19

Here below the results for the RC are presented. In the second and third column the coupon and the issue price are presented respectively. The fourth column indicates the fair value price. It is clear that here again the fair value 55

is very close to the issue price. The fair value price lower than the issue price indicates that the client is paying more than he should be doing. But here again there are fair values which are above the issue price (B, F, G, I and J). This issue will be examined more in detail in the discussion part. In the fth column the fair value is indicated when volatility spread is added. Here again, because the put is sold, the volatility will be reduced by 1% point. Therefore the premium collected by the sold put will be smaller and the price higher for such a structure. Here again the situation reported below indicates that 8 out of 10 SPs are under priced when the volatility spread of 1% is added, there it follows that even less than 1% point is charged. name A B C D E F G H I J rate price 14.50 100 9.76 100 15.00 100 10.50 100 11.50 100 14.00 100 13.00 100 9.30 100 13.00 100 13.125 100 pricef v 99.17 100.47 99.80 99.40 99.72 101.65 100.54 99.92 100.52 100.83 pricef vinc.vol.spread 99.52 100.78 100.14 99.79 100.05 102.31 100.94 100.27 100.92 101.22 deviation1 deviation2 0.83 0.48 -0.47 -0.78 -0.14 0.20 0.60 0.21 0.28 -0.05 -1.65 -2.31 -0.54 -0.94 0.08 -0.27 -0.52 -0.92 -0.83 -1.22

For both structures the critical input parameter was again the volatility. For the calculations done here the implied volatility15 calculated from a weighted average of the volatilities of the three call options closest to the ATM has been used. b) Bonus Certicate and Barrier Reverse Convertible Note Contrary to the rst part of this subsection, the barrier options get involved when these two products are considered. For a BC, the investor buys again a LEPO and a down-and-out put option, which barrier is usually set between 60-80%. That means, that the two options cancel out in the range between the strike of the call and the barrier of the put and anywhere else the call determines the payo of the SP. A BRC is slightly modied compared to the classic RC. Here, the clients is not selling a plain vanilla put, rather a
This volatility can be obtained on bloomberg via the function hist call imp vol available for those securities.
15

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down-and-in put. The barrier option in both SPs is of intrinsic type. Thus, these options will be dicult to hedge and therefore the barrier will be shifted. Moreover, it has been shown above that barrier option in general should not be priced by the BS model. And this is actually what the [4] applied when they calculated the fair values of the SPs. In the calculations conducted here, the local volatility model has been applied. The pricing has been conducted by a pricing tool of an IB, which will stay anonymous. The results are here again as expected. The deviation of the theoretical fair value from the market price is smaller for the SPs priced by the local volatility model. But still, the deviation from the theoretical fair value can not be neglected. The most important driver of the overshooting is the barrier shifting, which as shown above, causes the barrier option to be up to 20% more expensive. Thus, if the barrier option is 10% of the portfolio, the deviation will be at least 2%. Additionally to that, even if the barrier shifting is included in the model, the theoretical fair value price deviate from the market price. Non of the SPs containing the barrier option had a fair value above the market value. H(2) will be conrmed, even though, the two researchers did not use the appropriate model. 4.2.4 Discussion

In the section above where the results have been presented, it has become clear that the SPs containing a plain vanilla option are pretty fairly priced. There were all in all 6 products which were even under priced; something which is almost too good to be true. When such a product is issued, there are a lot of people involved in the process such as sales, trading, legal and compliance just to mention the most important. And all of them need to be paid! However, the result still showed that the SPs containing the plain vanilla option are competitively priced. The fair value price of the SPs should denitely be below the market price. So, what could be the error? All the products priced in this diplom thesis have been priced using the closing level of all the input parameters. Some of the SPs presented above have been priced during a trading day. The markets in the rst half of the year 2008 have signicantly decreased. The daily changes in prices and volatilities were relatively extreme. So if a certain security has dropped dramatically, the implied volatility has increased 57

dramatically due to the negative correlation. And for both SPs containing the plain vanilla option (DC and RC), this eect has a positive impact on their price since they both sell an option. Therefore, a SP priced at the end of the day will have either a higher coupon or a higher discount, which in turn allows us to argue that the extremely volatile markets can partly explain this under priced SPs which were priced during a trading day. In the rst half of the year 2008, the nancial sector continued the very negative trend which was initiated by the subprime crises in 2007. Most of the nancial rm stocks fell to a relatively very low level due to huge write downs and decreasing client condence. This on the other hand, had a negative impact on the credit default swaps (CDS) which are positively correlated with the volatility. CDS are of crucial importance when bonds are issued, which is the case when an option needs to be hedged. Since the option can be hedged by a portfolio consisting of stocks and bonds, the high CDS indicate again that the price oered can not be far away from the fair value.

Conclusion

In the empirical part 1, it has been shown that the price obtained by the trinomial tree method converges much faster to the BS price than the price obtained by the binomial tree method when the plain vanilla option is priced. MCS provides an accurate price as well. When the barrier option is priced, the trinomial tree method should be used again, but a modication suggested by Kamrad and Ritchken[16] needs to be included. Here again, the MCS provides a good result too. In the empirical part 2, it has been shown that a barrier option should not be priced with the BS model, rather the local volatility model should be applied. There, a barrier shifting is needed due to hedging diculties and discontinuity. That means that the down-and-out put is too expensive because the barrier is shifted to the left. It has been shown that a barrier shifting from 2.5-3% (which is, by the way, a very realistic case) makes the exotic option up to 20% more expensive. The major price driver of the barrier option is the skew and not the absolute value of the implied volatility. The steeper the skew, the cheaper the down-and-out put option and vice versa. In the application part 1, a SP (Bonus Certicate) containing such a 58

barrier option has been examined thoroughly. The clients, IBs and asset managers point of view have been reported. From the clients point of view, it has been shown that including the derivatives in the portfolio can increase the investors utility (the overlay strategy). This has been shown with the plain vanilla options, but a similar result can be expected with the barrier options. From the asset managers point of view, especially the Greeks (Delta, Gamma and Vega) and their dynamics, should be reviewed briey. On the one hand, the Delta, and therefore the Gamma, could become very high when the underlying approaches the barrier close to maturity. On the other hand, the sign of the both switches at some point when the underlying approaches the barrier. In the application part 2, it has been shown that SPs with a plain vanilla option as a component, such as DC and RC, are not overpriced relative to their theoretical fair value. The SPs with a barrier option as building component of that SP are strictly overshooting the theoretical fair value, even then when the local volatility model has been applied and the barrier hedging has been accounted for.

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