DER 05.2 Arbitrage relations: Options
Call and put options on assets, forwards, futures, and swaps also trade. Certain price relations among these instruments exist solely due to the absence of costless arbitrage opportunities. The most important of these is called put-call parity.
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Required reading
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Whaley, 2006, Ch. 6, No-arbitrage price relations: Options
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Whaley 2021, The "Sage" entrepreneur (teaching note)
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Lecture notes
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Supporting files
DER 07 OPTION VALUATION: ANALYTICAL FORMULAS
Valuing an option relative to its underlying benchmark requires an assumption about the benchmark’s price distribution. Under the assumption that the benchmark’s price distribution is lognormally distributed, many valuation results may be derived. One such valuation result is the infamous Black-Scholes European-style option valuation formula.
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Required reading
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Whaley, 2006, Ch. 7, Valuing standard options analytically
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Steiner, 2012, Ch. 1, Wall street: The first domino
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Lecture notes
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Slides
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Supporting files
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OPTION VALUATION: BINOMIAL METHOD
Some options, because of their contract design, do not have analytical valuation formulas (e.g., American-style options). Nonetheless, they can be valued accurately using approximations. The most popular among these is the binomial method.
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Required reading
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Whaley, 2006, Ch. 9, Valuing options numerically (pp. 303-319)
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Lecture notes
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Supporting files
OPTION VALUATION: MONTE CARLO SIMULATION
Some options are written on the prices of more than one asset. Most of them do not have analytical valuation formula. Nonetheless, they can be valued accurately using approximations. The most versatile of these is Monte Carlo simulation.
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Required reading
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Whaley, 2006, Ch. 9, Valuing options numerically (pp. 328-337)
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Lecture notes
RISK MEASUREMENT
The importance of option valuation is not driven solely by the desire to identify mispriced options. Its greatest value lies in providing managers with the ability to measure risk exposures.
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Required reading
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Whaley, 2006, Ch. 7, Valuing standard options analytically (pp. 234-248)
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Lecture notes
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Supporting files
MANAGING RISK DYNAMICALLY
With the ability to measure risk, we create the ability to manage risk through time.
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Required reading
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Whaley, 2006, Ch. 10, Risk management strategies: Options (pp. 347-362)
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Saletta 20210128 What is a gamma squeeze? The Motley Fool.
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Lecture notes
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Supporting files
EARNING EMBEDDED CONTRACT FEES
The terms of OTC contracts are often written in such a way that there is no obvious cost. The fees charged by the dealer are embedded. The embedded fees can be deduced using techniques such as Monte Carlo simulation.
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Required reading
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Lecture notes
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Supporting files
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Ted Turner collar valuation.xlsx
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Earning embedded fee dynamically.xlsx
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PASSIVE OPTION STRATEGIES
Passive option strategies are ones that are opened today and held to expiration. The expected returns/risks of these strategies can be computed straightforwardly using Monte Carlo simulation.
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Required reading
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Lecture notes
NOTE: All of the above ideas and techniques can be applied without identifying the specific nature of the asset underlying the derivatives contract. They are generic. In what lies below, we discuss how the ideas and techniques are applied to derivatives contracts written on specific assets.
STOCK INDEX FUTURES
The cost of carry model is adapted to the case where the underlying asset is a stock index like the S&P 500 index. Stock index futures are shown to be a cost-efficient and effective means of managing the risk of stock portfolios.
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Required reading
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Whaley, 2006 Ch. 14 Stock index products: Futures and options
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Whaley, 2006 Ch. 15 Stock index products: Strategy-based
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Lecture notes
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Supporting files
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Index return statistics 20091231-20191231.xlsx
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S&P 500 index dividends.xlsx
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STOCK INDEX OPTIONS
Valuation models show how stock index options can be used to structure various types of index products such as protected equity notes and portfolio insurance.
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Required reading
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Whaley, 2006 Ch. 14 Stock index products: Futures and options
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Whaley, 2006 Ch. 15 Stock index products: Strategy-based
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Bollen and Whaley 2004 Does net buying pressure affect the shape of implied volatility functions? JF
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Lecture notes
STOCK DERIVATIVES
Futures and options on individual stocks are also traded on exchanges and in over-the-counter (OTC) markets, and lend themselves to various strategies such as capturing dividends and acquiring shareholder voting rights.
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Required reading
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Whaley, 2006, Ch. 11, Stock products
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Frankel, 2012, Dividend play in S&P 500 ETF goes awry, costs traders $20 million
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Lecture notes
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Supporting files
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Early exercise of call.xlsx
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COMPENSATION CONTRACTS
The most common OTC stock option contract category is executive stock options. Understanding how to value these contracts is critical in measuring the economic impact that they have on shareholder wealth.
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Required reading
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Whaley, 2006, Ch. 13, Compensation contracts
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Lecture notes
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Slides
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Supporting files
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