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how to model the behaviour of many assets simultaneously estimating correlation between asset price movements how to value and hedge options on many underlying assets in the BlackScholes framework the pricing formula for European non-path-dependent options on dividend-paying assets
2 Introduction
In this lecture we see the idea of higher dimensionality by examining the BlackScholes theory for options on more than one underlying asset. This theory is perfectly straightforward; the only new idea is that of correlated random walks and the corresponding multifactor version of Its lemma. Although the modeling and mathematics is easy, the final step of the pricing and hedging, the solution, can be extremely hard indeed. We see what makes a problem easy, and what makes it hard, from the numerical analysis point of view.
This is readily extended to a world containing many assets via models for each underlying
G6
L
{ L6 L G W L6 L G ;
G , and { L and L Here 6 L is the price of the Lth asset, L are the drift and volatility of that asset respectively and G ; L is the increment of a Wiener process.
4 We can still continue to think of G ; L as a random number drawn from a Normal distribution with mean zero and standard deviation GW so that
( >G ; L@
and
( >G ;
M
L@
GW
are correlated:
LM G W
G;
M@
here LM is the correlation coefficient between the Lth and M th random walks.
G
The symmetric matrix with LM as the entry in the Lth row and M th column is called the correlation matrix.
5 For example, if we have seven underlyings G tion matrix will look like this:
M L.
where M is the matrix with the L along the diagonal and zeros everywhere else.
6 To be able to manipulate functions of many random variables we need a multidimensional version of Its lemma. If we have a function of the variables 6 ,. . . ,6 G and W, 9 6 6 G W, then
G9
'
9
; ;
G G L
L M LM 6 L6
# 9
M
M
# 6 L# 6
/9 ;
G
#9 #6
L
G 6 L
L
We can get to this same result by using Taylor series and the rules of thumb: G ; L G W and G ; LG ; M LM G W
4 Measuring correlations
If you have time series data at intervals of s W for all G assets you can calculate the correlation between the returns as follows. First, take the price series for each asset and calculate the return over each period. The return on the Lth asset at the N th data point in the time series is simply
5 LWN 6 LWN s W > 6 LWN 6 LWN
; : : 9
I 9
;
>
# L9N > #{ L
N
where is the number of data points in the return series and 5{ L is the mean of all the returns in the series.
;
>
5 LWN > 5{ L5
M WN
> 5{ M
N
;
0 M N
> P LP
# L9N > 5{ L5
M WN
> 5{ M
9 Correlations measured from financial time series data are notoriously unstable.
1.0 0.8
0.6
0.4
0.2
1.A correlation time series. The other possibility is to back out an implied correlation from the quoted price of an instrument. The idea behind that approach is the same as with implied volatility, it gives an estimate of the markets perception of correlation.
10
;
G
@ L6 L
L
'
; ;
G G L M
9
P LP M LM 6 L6
# 9
M
# 6 L# 6
w ' ; / 9
G L
N
> @
L L
$
G 6 L
If we choose
@ #9
L
#6
for each L, then the portfolio is hedged, is risk-free. Setting the return equal to the risk-free rate we arrive at
#9 #W
; ;
G G L
P LP M LM 6 L6
# 9
M
M
# 6 L# 6
U
M
;
G
#9
L
L
#6
> U9
L
(1)
12 The modifications that need to be made for dividends are obvious. When there is a dividend yield of ' L on the Lth asset we have
#9 #W
; ;
/ G L
P LP M LM 6 L6
# 9
M
M
# 6 L# 6
M
;
G
7 > L$
'
L
L
$
> 7'
L
13
9
> 7 % > 9
~ 7 > W
> /
???
Payoff$ ??? $ /
DetE
>
$
??? $
M M$ N M
OR J
L
H[ S
>
>
N N
??? P /
/$
>
F
L
??? / $ /
L7 > 9
7 >
>
N (2)
% > 9
L
on
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> T 6
where T and T are constants. The partial differential equation satisfied by this option in a Black Scholes world is
#9 #W
; ;
L
P LP M LM 6 L6
# 9
M
M
# 6 L# 6
M
7 > L$
'
L
L
$
> 7'
L
A dividend yield has been included for both assets. Since there are only two underlyings the summations in these only go up to two.
15 This contract is special in that there is a similarity reduction. Lets postulate that the solution takes the form
9 6 6 W T 6 + } W
If this is the case, then instead of finding a function 9 of three variables, we only need find a function + of two variables, a much easier task. Changing variables from 6 6 to } we must use the following for the derivatives.
# #6 #
# 6#} } 6
# #6
>
} # 6#} #
} 6
#6
6
#}
#6
#}
} # 6
#}
# 6 # 6
>
#}
>
6
# #}
+
#}
>
}
#+ #}
> '
+
where
>
Y ou will recognise this equation as being the BlackScholes equation for a single stock with ' in place of U , ' in place of the dividend yield on the single stock and with a volatility of .
17 From this it follows, retracing our steps and writing the result in the original variables, that
9 6 6 W T 6 0
>
%
> 9
/ > 6 $ 0
P %
>
%
> 9
/
where
/
OR J 6 $ 6 $ P
>
> 9
% > 9
and
/
/ >
7 > W
18 The next example is of basket equity swap. This rather complex, high-dimensional contract, is for a swap of interest payments based on three-month LIBOR and the level of an index. The index is made up of the weighted average of 20 pharmaceutical stocks. To make matters even more complex, the index uses a time averaging of the stock prices.
Notional Amount
Counterparty floating amounts (US$ LIBOR) Floating Rate Payer Floating Rate Index Designated Matrurity Spread Day Count Fraction Floating Rate Payment Dates Initial Floating Rate Index The Bank Fixed and Floating Amounts (Fee, Equity Option) Fixed Amount Payer Fixed Amount Fixed Amount Payment Date Basket
[] USD-LIBOR Three months Minus 0.25% Actual/360 Each quarterly anniversary of the Effective Date []
XXXX 1.30% of Notional Amount Effective Date A basket comprising 20 stocks and constructed as described in attached Appendix Will be set at 100 on the Initial Valuation Date XXXX
Will be calculated according to the performance of the basket of stocks in the following way:
BASKET average 100 Notional Amount * max 0, 100
where
BASKET average = 100 * Paverage Weight * P 120 stocks initial
And for each stock the Weight is given in the Appendix P_initial is the local currency price of each stock on the Initial Valuation Date P_average is the arithmetic average of the local currency price of each stock on each of the Averaging Dates Termination Date
Appendix Each of the following stocks are equally weighted (5%): Astra (Sweden), Glaxo Wellcome (UK), Smithkline Beecham (UK), Zeneca Group (UK), Novartis (Switzerland), Roche Holding Genus (Switzerland), Sanofi (France), Synthelabo (France), Bayer (Germany), Abbott Labs (US), Bristol Myers Squibb (US), American Home Products (US), Amgen (US), Eli Lilly (US), Medtronic (US), Merck (US), Pfizer (US), Schering-Plough (US), Sankyo (Japan), Takeda Chemical (Japan).
This indicative termsheet is neither an offer to buy or sell securities or an OTC derivative product which includes options, swaps, forwards and structured notes having similar features to OTC derivative transactions, nor a solicitation to buy or sell securities or an OTC derivative product. The proposal contained in the foregoing is not a complete description of the terms of a particular transaction and is subject to change without limitation.
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existence of a closed-form solution number of underlying assets, the dimensionality path dependency early exercise We have seen most of these in a single-asset setting. The solution technique that we use will generally be one of finite-difference solution of a partial differential equation numerical integration Monte Carlo simulation
G G G
22 8.1 Easy problems If we have a closed-form solution then our work is done; we can easily find values and hedge ratios. This is provided that the solution is in terms of sufficiently simple functions for which there are spreadsheet functions or other libraries. If the contract is European with no path-dependency then there may be a solution in the formof a multiple integral. If this is the case, then we often have to do the integration numerically. 8.2 Medium problems If we have low dimensionality, less than three or four, say, the finitedifference methods are the obvious choice. They cope well with early exercise and many path-dependent features can be incorporated, though usually at the cost of an extra dimension. For higher dimensions, Monte Carlo simulations are good. They cope with all path-dependent features. Unfortunately, they are not very efficient for American-style early exercise.
23 8.3 Hard problems The hardest problems to solve are those with both high dimensionality, for which we would like to use Monte Carlo simulation, and with early exercise, for which we would like to use finite-difference methods. There is currently no numerical method that copes well with such a problem.
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