SMM503

Structured Products

Lecture 3
Advanced & Exotic Options
"I Never invest in any idea you can't illustrate with a crayon."
Peter Lynch.

2
INTRODUCTION

■Last week we covered the basics of options

□By now you should be familiar with the basic payoff diagrams & how to combine them to
produce various strategies

■These week we will cover options in more depth & introduce exotic options

3
 A
GREEK
MASTER CLASS
A REMINDER OF THE GREEKS
Change in price of option for change
DELTA
in price of underlying
Change in Delta for change in price of
GAMMA
underlying
Change in price of option for 1%
VEGA
change in volatility
Theta is the rate of change of the
THETA
options value as time (1 day) passes
Rho is change in the price of the
RHO option for a 1% change in interest
rates
5
VALUE OF A CALL OPTION OVER TIME
Value Of a 100 Strike Call
60.0

50.0

40.0

30.0
Value

20.0

10.0

0.0
50

60

70

80

90

100

110

120

130

140

150
-10.0
Asset Price
1 Year to Expiry 6 Month to Expiry 1 Month to Expiry At Expiry
6
VALUE OF A PUT OPTION OVER TIME
Value Of a 100 Strike Put
60.0

50.0

40.0

30.0
Value

20.0

10.0

0.0
50

60

70

80

90

100

110

120

130

140

150
-10.0
Asset Price
1 Year to Expiry 6 Month to Expiry 1 Month to Expiry At Expiry
7
DELTA

■ Defined as the rate of change of an option price with respect to the price of the
underlying asset. It is the slope of the curve that relates the option price to the
underlying asset price. i.e. how much do you make or lose on the option as the
underlying asset moves.

c
 call = = N (d1 )
S
p
 put = = N (d1 ) − 1
S
8
DELTA

■ From these formulae it should be clear that the delta of a call is always between
0 and 1 while the delta of a put is between 0 and -1.

■ A portfolio that consists of an option and a position in the underlying asset equal
to the inverse of the delta will be “delta neutral” or “delta hedged”.

■ i.e. to hedge a long call position you go short the asset while to hedge a long put
position you go long the asset.

9
DELTA
Delta of 100 Strike Call vs Price Of Underlying Asset Over Time
1.0
0.9
0.8
0.7
0.6
Delta

0.5
0.4
0.3
0.2
0.1
0.0
50

60

70

80

90

100

110

120

130

140

150
Asset Price
Delta 1 Year to Expiry Delta 6 Months to Expiry Delta 1 Month to Expiry 10
DELTA
Delta of 100 Strike Put vs Price Of Underlying Asset Over Time
0.0 50

60

70

80

90

100

110

120

130

140

150
-0.1
-0.2
-0.3
-0.4
Delta

-0.5
-0.6
-0.7
-0.8
-0.9
-1.0
Asset Price
Delta 1 Year to Expiry Delta 6 Months to Expiry Delta 1 Month to Expiry 11
DELTA

■ Delta Hedge Example

□Assumptions:
- S0 = 100, K=100, σ = 25%, r=5%, T=1

□Therefore:
- Call Price = 12.34 and Δ = 0.63

□Delta Hedged Portfolio:

- Buy 1 Call Option and Sell 0.63 of asset

12
DELTA

■Delta Hedge Example (cont)

□If the asset price rises to 101

- Call Price = 12.97 and Δ = 0.64

□Delta Hedged Portfolio:

- Profit on long Call = 12.97-12.34 = 0.63
- Loss on Short Asset = 0.63

□So the Delta hedge worked perfectly, but are we still hedged?

13
DELTA

■ Delta Hedge Example (cont)

□ Now Δ = 0.64 so we need to sell another 0.01 of the asset at 101.

□ The delta increases as the price rises and falls as the price falls so we will be
continuously adjusting the hedge.

□ Do we make or lose money as we are hedging?

14
DELTA

■ Delta Hedge Example (cont)

□ If the realised volatility over the life of the option is identical to the volatility we used to
price the option and we can continuously adjust our hedge (with no transactions costs)
then the profit we make on our delta hedging will exactly offset the premium paid for the
option.

15
GAMMA

■ Gamma (Γ) is defined as the rate of change of delta (Δ) with respect to the price
of the underlying asset. It is the slope of the delta curve. i.e. how much does
your delta change as the underlying asset moves.

N (d1 )
option =
S 0 t
where
1 − d1 2
2

N (d1 ) = e
2
16
GAMMA
Gamma of 100 Strike Call vs Price Of Underlying Asset Over Time
0.06

0.05

0.04
Gamma

0.03

0.02

0.01

0.00
50

60

70

80

90

100

110

120

130

140

150
Asset Price

Gamma 1 Year to Expiry Gamma 6 Months to Expiry Gamma 1 Month to Expiry 17

GAMMA

■ Long vanilla options have positive gamma & short option have negative Gamma.
□ Gamma is greatest for options that are close to the money.

■ Imagine the scenario 30 seconds before expiry of a 100 strike call

□ If the asset price is 99 what is your delta?
□ If the asset price is 101 what is your delta?

18
GAMMA

■ Hedging gamma is more complex that hedging delta because the underlying
asset has zero gamma.

■ Gamma can only be hedged with other option positions.

19
VEGA

■ Vega (ν) is defined as the rate of change of the value of an option with respect to
volatility. i.e. how much does your option price change as implied volatility moves.

 option = S 0 N (d1 ) T
where
1 − d12
N (d1 ) = e 2
2
20
VEGA
Vega of 100 Strike Call vs Price Of Underlying Asset Over Time
0.40

0.35

0.30

0.25
Vega

0.20

0.15

0.10

0.05

0.00
50

60

70

80

90

100

110

120

130

140

150
Asset Price

Vega 1 Year to Expiry Vega 6 Months to Expiry Vega 1 Month to Expiry

21
VEGA

■ Long options have positive vega & short option have negative vega.
□ Vega is greatest for options that are close to the money

■ Imagine the scenario 30 seconds before expiry of a 100 strike call

□ If the asset price is 99 what is your vega (do you want the price to move?)
□ If the asset price is 110 what is your vega?

22
VEGA

■ As with Gamma, you cannot hedge vega risk with the underlying asset because
the underlying asset has zero vega.

■ Hence vega can only be hedged with other option positions.

23
THETA

■ Theta (Θ) is defined as the rate of change of the value of an option with respect
to the passage of time. i.e. how much do you make or lose on the option as the
one day passes.

S 0 N (d1 )
 call = − − rKe − rT N (d 2 )
2 T
S 0 N (d1 )
 put = − + rKe − rT N (−d 2 )
2 T
24
THETA

■ The theta of a long call or put is usually negative. This means that, if time
passes with the price of the underlying asset and its volatility remaining the same,
the value of a long option declines.

□ If you refer back to slides 6 & 7 you should be able to spot one exception to this rule

25
THETA
Theta of 100 Strike Call vs Price Of Underlying Asset Over Time
0.00
50

60

70

80

90

100

110

120

130

140

150
-0.01

-0.02
Theta

-0.03

-0.04

-0.05

-0.06
Asset Price

Theta 1 Year to Expiry Theta 6 Months to Expiry Theta 1 Month to Expiry

26
THETA
Theta of 100 Strike Put vs Price Of Underlying Asset Over Time
0.02

0.01

0.00
50

60

70

80

90

100

110

120

130

140

150
-0.01
Theta

-0.02

-0.03

-0.04

-0.05
Asset Price

Theta 1 Year to Expiry Theta 6 Months to Expiry Theta 1 Month to Expiry

27
THETA

■ Long options have negative theta & short option have positive theta (with small
exceptions).
□Theta is greatest for options that are close to the money

■Does hedging theta make sense?

□ there is no uncertainty about the passage of time

28
RHO

■ Rho (ρ) is defined as the rate of change of the value of an option with respect to
the interest rate. i.e. how much do you make or lose on the option as interest
rates move.

 call = KTe − rT
N (d 2 )
 put = − KTe − rT
N (−d 2 )

29
RHO
Rho of 100 Strike Call vs Price Of Underlying Asset Over Time
1.00
0.90
0.80
0.70
0.60
Rho

0.50
0.40
0.30
0.20
0.10
0.00
50

60

70

80

90

100

110

120

130

140

150
Asset Price

Rho 1 Year to Expiry Rho 6 Months to Expiry Rho 1 Month to Expiry

30
RHO
Rho of 100 Strike Put vs Price Of Underlying Asset Over Time
0.00
50

60

70

80

90

100

110

120

130

140

150
-0.10
-0.20
-0.30
-0.40
Rho

-0.50
-0.60
-0.70
-0.80
-0.90
-1.00
Asset Price

Rho 1 Year to Expiry Rho 6 Months to Expiry Rho 1 Month to Expiry

31
RHO

■ Rho is positive for Calls and negative for puts with the magnitude increasing as
the delta increases.

■ This is because as rates increase the forward price will increase (remember
lecture 1), hence calls will increase in price and puts will decrease.

32
VOLATILITY
SMILES
VOLATILITY SMILES

■ The “volatility smile” is the relationship between implied volatility and strike price
for options with a certain maturity

■ The volatility smile for European call options should be exactly the same as that
for European put options (put call parity)

■ The volatility surface is the relationship between implied volatility across strike
prices and time to maturity.

34
FTSE VOLATILITY SURFACE

35
VOLATILITY SMILES

■ For equity options lower strike price volatilities are much higher than the higher
strike price volatilities, hence the “smile”

Implied
Volatility

Strike
Price 36
VOLATILITY SMILES

■ You will recall that the Black Scholes model assumes that prices are distributed
lognormally.
□ In reality the distribution does not look like this.
□ The empirical distribution has a fatter left tail (higher probability of a big downmove)

■ The key issue is that Black-Scholes does not determine option prices, the
market does that. Black-Scholes is simply a sophisticated model that
approximates (very well) market prices.

37
VOLATILITY SMILES

■ Given the implied volatilities we can infer the implied distribution of stock prices.

Implied Distribution

Lognormal Distribution

38
VOLATILITY SMILES

■ Further Explanations

□ Asset price exhibits jumps rather than continuous changes

□ Volatility for asset price is stochastic

- In the case of equities volatility is negatively related to stock prices (prices move up slowly and
down quickly). This is consistent with the skew that is observed in practice

39
VOLATILITY SMILES

■ The volatility term structure is much simpler.

□ It tends to be downward sloping when volatility is high and upward sloping when it is
low

■ This implies that there is a long term average volatility.

40
VOLATILITY SMILES

■ Implications of the volatility smile

■ Using a flat volatility surface is flawed and dangerous because it does not reflect
the true distribution of the underlying asset
- Under value out of the money puts (portfolio insurance)
- Underestimate the delta of out of the money options (under hedged)

41
EXOTIC
OPTIONS
EXOTIC OPTIONS

■ There are literally dozens of different exotic options, however we will focus on
only the 4 main categories that are relevant to the structured products we will
cover in this course (we could spend 10 weeks just covering exotic options)

□ Barrier Options
□ Binary Options
□ Asian Options
□ Basket Options

43
EXOTIC OPTIONS

■ When modelling exotic options, one has to make a fundamental decision very
early in the process: should you model the option in a continuous-time, Black-
Scholes type of model, or in a binomial model.
- Generally many exotic options are initially priced via a binomial model, and then at some point
traders figure out a closed-form pricing model.
- Sometimes, it turns out that no closed form solution is ever found.
- Indeed, for certain highly path-dependent options, one cannot even work backwards in a
lattice, instead one must use a Monte-Carlo method to value the option.

44
EXOTIC OPTIONS

■ In this course you are NOT expected to be able to produce models to price
exotic options. You ARE however expected to understand:
- The payoff diagrams of exotic options
- Whether the price of the exotic is higher or lower than the vanilla option
- The reasons for using exotic options and the inherent risks
- The factors that drive the options price

45
EXOTIC OPTIONS ON BLOOMBERG (OVME)

46
BARRIER OPTIONS

■ Barrier options are options that have a payout that is dependent not only on the
terminal stock price, but also depend upon whether the stock attains some
“barrier” during the life of the option. Two general kinds:

□ Knock-out options: The option ceases to exist if the stock reaches a given barrier
during the options life.

□ Knock-in options: The option comes into being only if the stock reaches a given
barrier during its life.

47
BARRIER OPTIONS
Up & Out Call, Strike 100, Barrier 130

35

30

25

20

15

10

0
50 60 70 80 90 100 110 120 130 140 150 48
BARRIER OPTIONS
Down & Out Put Strike 100, Barrier 70

35

30

25

20

15

10

0
50 60 70 80 90 100 110 120 130 140 150 49
BARRIER OPTIONS
Up & In Call Strike 100, Barrier 130

60

50

40

30

20

10

0
50 60 70 80 90 100 110 120 130 140 150 50
BARRIER OPTIONS
Down & In Put Strike 100, Barrier 70

60

50

40

30

20

10

0
50 60 70 80 90 100 110 120 130 140 150 51
BARRIER OPTIONS
UP & IN CALL + UP & OUT CALL = CALL

=
52
BARRIER OPTIONS

■ Closed form solutions exist for the pricing of barrier options (see Hull) though
due to stochastic volatility Monte Carlo simulations might also be used.

■ The Greeks (we will only really cover Δ) are a little more complex, see next slide

53
BARRIER OPTIONS
Value Of an UP & OUT Call, Stirke 100, Barrier 130
30.0

25.0

20.0
Value

15.0

10.0

5.0

0.0
50

60

70

80

90

100

110

120

130

140

150
Asset Price
1 Year to Expiry 6 Month to Expiry 1 Month to Expiry At Expiry
54
BARRIER OPTIONS

■ Recall that Delta Δ is the slope of the value vs underlying asset line.

■ For an up & out call the delta is not always positive (sometimes the line has
negative slope), this is very different from a vanilla call. This is because as we
approach the barrier there is a higher likelihood that the option will be “knocked
out” which will result in a zero payoff and hence the value falls.

55
BARRIER OPTIONS
Value Of UP & IN Call, Stirke 100, Barrier 130
50.0
45.0
40.0
35.0
30.0
Value

25.0
20.0
15.0
10.0
5.0
0.0
50

60

70

80

90

100

110

120

130

140

150
Asset Price
1 Year to Expiry 6 Month to Expiry 1 Month to Expiry At Expiry 56
BINARY OPTIONS

■ A Binary Option is basically a standard option, but one in which the payout is
altered such that it only pays a fixed amount if the option ends up in the money.

□ In a cash or nothing binary, the amount is a lump sum and the premium is quoted as
a percentage of that lump sum

57
BINARY OPTIONS
Binary Cash or Nothing Call, Strike 100

100.00%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
50 60 70 80 90 100 110 120 130 140 150 58
BINARY OPTIONS
Binary Cash or Nothing Put, Strike 100

100.00%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
50 60 70 80 90 100 110 120 130 140 150 59
ASIAN OPTIONS

■ The term Asian Option means an option where the payoff to the option
is a function of the average price of the underlying for some portion of the
life of the option

□There are actually many variants of Asian options available.

- Average price call: max(0,Save-K)
- Average price put: max(0,K-Save)

□The method for calculating the average can vary.

- Usually it is the arithmetic average, but can be the geometric average.
- If arithmetic average, usually no closed form solution exists, although Hull presents
some approximations. Typically will rely upon Monte Carlo procedures to determine
the value.
60
ASIAN OPTIONS

■ The period of from which the average is taken can vary tremendously:
- Daily over life of the option.
- Daily over last n days of option’s life.
- Daily over first n days of option’s life.
- Weekly, monthly, etc.
- From specific days during the life of the option

■ As the volatility of the average is lower than that of the spot itself, the price of
Asian options are generally lower than the European ones

61
BASKET OPTIONS

■ As its name suggests a Basket Option is simply an option on a basket of assets,

a common example is an equity index option.

■ How does the price of an index option relate to the movements of the underlying
stocks?

■ Hopefully by now you will know that the option price is related to the volatility of
the underlying asset

62
BASKET OPTIONS

■ The volatility of the basket can be approximated from the individual volatilities of
the assets in the basket & their correlations.
 basket
2
  wi w j  i , j i j
i, j
□ As long as the correlations are less that 1, then the volatility of the basket will be lower
than the weighted average of the individual underlying assets.

■ Hence the option on the basket is cheaper than the sum of options on each
individual underlying

63
BASKET OPTIONS

■ The payoff of a basket option does not always have to be related to the
performance of the basket, there are also Best Of and Worst Of Options
(sometimes these are referred to as rainbow options).

- A Best Of option pays the difference between the best performing asset in the basket and the
strike price
- A Worst Of option pays the difference between the worst performing asset in the basket and
the strike price

64
BASKET OPTIONS

■ Once again the price of Best Of and Worst Of Options depends on both the
volatilities and the correlations of the basket components

■ General idea is that when the correlation is low (or even negative) there is a
more diverse range of outcomes, hence there will always be one asset which has
outperformed and one that has under performed (think about the case of perfect
negative correlation).

65
BASKET OPTIONS

■ The effect of volatility is obvious (hopefully), the effect of correlation on best of

and worst of options is summarised in the table below

Call Put
Best Of - +
Worst Of + -

66
BASKET OPTIONS

■ Best Of and Worst Of Options are used extensively in structured products to

make them look more attractive.

■For example:
- Buying a best of option provides the opportunity to benefit from the best payout of a group of
underlying assets, at a lower cost than buying individual vanillas of all the underlying assets
separately

67
EXOTIC OPTIONS SUMMARY

You Get
What You
Pay For!
68
HOMEWORK
Homework

Compulsory
▪ Read the Bloomberg article on Moodle – be ready to discuss in class

▪ Problem set on Moodle – be ready to discuss in class

Optional
Options, Futures and Other Derivatives by John C. Hull
Chapter 19 – The Greek Letters
Chapter 20 – Volatility Smiles
Chapter 26 – Exotic Options

70
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