Lecture On Swaps

15.
401
15.401 Finance Theory

MIT Sloan MBA Program
Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School
Lectures 1011: Options
20072008 by Andrew W. Lo
Critical Concepts
15.401
Motivation
Payoff Diagrams
Payoff Tables
Option Strategies
Other Option-Like Securities
Valuation of Options
A Brief History of Option-Pricing Theory
Extensions and Qualifications
Readings:
Brealey, Myers, and Allen Chapters 27
Lecture 1011: Options
Slide 2
Motivation
15.401
Derivative: Claim Whose Payoff is a Function of Another's

Warrants, Options
Calls vs. Puts
American vs. European
Terms: Strike Price K, Time to Maturity
At Maturity T, payoff
Slide 3
Motivation
15.401
Put Options As Insurance
Differences
Early exercise
Marketability
Dividends
Slide 4
Payoff Diagrams
15.401
Call Option:
12
10
Payoff / profit, $
8
6
4
2
Stock price
0
10
15
20
25
30
-2
Slide 5
Payoff Diagrams
15.401
Stock Return vs. Call Option Return

133%
100%
67%
33%
0%
30
34
38
42
46
50
54
58
62
66
70
-33%
-67%
-100%
-133%
Slide 6
Payoff Diagrams
15.401
Put Option:
12
10
Payoff / profit, $
8
6
4
2
Stock price
0
10
15
20
25
30
-2
-4
Slide 7
Payoff Diagrams
15.401
25
25
20
20
Long Call
15
10
10
0
30
40
-5
Long Put
15
50
60
70
-5
Stock price
30
40
70
60
70
Stock price
Stock price
0
30
40
-5
-10
60
Stock price
50
50
60
70
30
40
50
-5
Short Call
-10
-15
-15
-20
-20
-25
-25
Short Put
Slide 8
Payoff Tables
15.401
Stock Price = S, Strike Price = X
Call option (price = C)

Payoff
Profit
if S < X
if S = X
if S > X
0
C
0
C
SX
SXC
if S < X
if S = X
if S > X
XS
XSP
0
P
0
P
Put option (price = P)

Payoff
Profit
Slide 9
Option Strategies
15.401
Trading strategies
Options can be combined in various ways to create an unlimited
number of payoff profiles.
Examples
Buy a stock and a put
Buy a call with one strike price and sell a call with another
Buy a call and a put with the same strike price
Slide 10
Option Strategies
15.401
Stock + Put
70
65
25
Payoff
Payoff
20
60
Buy stock
55
Buy a put
15
50
10
45
40
35
30
30
40
50
Stock price
60
70
30
40
50
Stock price
60
70
70
65
Payoff
60
55
50
45
Stock + put
40
35
30
30
40
50
Stock price
60
70
Slide 11
Option Strategies
15.401
Call1 Call2
25
20
25
Payoff
20
15
15
10
5
Buy call with

X = 50
10
5
Write call with

X = 60
0
-5 30
Payoff
40
-10
50
60
70
Stock price
-5 30
-15
-20
-20
50
60
70
Stock price
-10
-15
20
40
Payoff
16
Call1 Call2
12
8
4
0
30
40
50
Stock price
60
70
Slide 12
Option Strategies
15.401
Call + Put
25
25
Payoff
20
15
15
Buy call with

X = 50
10
0
30
40
Buy put with

X = 50
10
-5
Payoff
20
50
60
70
-5
Stock price
-10
30
40
50
60
70
Stock price
-10
25
Payoff
20
15
Call + Put
10
5
0
-5
30
40
50
60
70
Stock price
-10
Slide 13
15.401
Corporate Liabilities:
Equity: hold call, or protected levered put

Debt: issue put and (riskless) lending
Quantifies Compensation Incentive Problems:
Biased towards higher risk
Can overwhelm NPV considerations
Example: leveraged equity
Slide 14
15.401
Other Examples of Derivative Securities:

Asian or Look Back Options
Callables, Convertibles
Futures, Forwards
Swaps, Caps, Floors
Real Investment Opportunities
Patents
Tenure
etc.
Slide 15
15.401
Binomial Option-Pricing Model of Cox, Ross, and Rubinstein (1979):

Consider One-Period Call Option On Stock XYZ
Current Stock Price S0
Strike Price K
Option Expires Tomorrow, C1= Max [S1K , 0]
What Is Todays Option Price C0?
0
S0 , C0 = ???
1
S1 , C1= Max [S1K , 0]
Slide 16
15.401
Suppose S0 S1 Is A Bernoulli Trial:
uS0
u>d
S1
1 p
dS0
Max [ uS0 K , 0 ] == Cu
1 p
Max [ dS0 K , 0 ] == Cd
C1
Slide 17
15.401
Now What Should C0 = f () Depend On?

Parameters: S0 , K , u , d , p , r
Consider Portfolio of Stocks and Bonds Today:
Shares of Stock, $B of Bonds
Total Cost Today: V0 == S0 + B
Payoff V1 Tomorrow:
uS0 + rB
1 p
dS0 + rB
V1
Slide 18
15.401
Now Choose and B So That:
uS0 + rB = Cu
V1
1 p
dS0 + rB = Cd
* = (Cu Cd)/(u d)S0

B* = (uCd dCu)/(u d)r
Then It Must Follow That:
C0 = V0 = S0 * + B* =
r d
u r
Cu +
C
ud
ud d
Slide 19
15.401
Suppose C0 > V0
Today: Sell C0 , Buy V0 , Receive C0 V0 > 0
Tomorrow: Owe C1, But V1 Is Equal To C1!
Suppose C0 < V0
Today: Buy C0 , Sell V0 , Receive V0 C0 > 0
Tomorrow: Owe V1, But C1 Is Equal To V1!
C0 = V0 , Otherwise Arbitrage Exists
C0 = V0 = S0 * + B* =
r d
u r
Cu +
C
ud
ud d
Slide 20
15.401
Note That p Does Not Appear Anywhere!

Can disagree on p, but must agree on option price
If price violates this relation, arbitrage!
A multi-period generalization exists:
Continuous-time/continuous-state version (Black-Scholes/Merton):
Slide 21
15.401
Earliest Model of Asset Prices:

Notion of fair game
The martingale
Cardanos (c.1565) Liber De Ludo Aleae:
The most fundamental principle of all in gambling is simply equal
conditions, e.g. of opponents, of bystanders, of money, of situation, of
the dice box, and of the die itself. To the extent to which you depart
from that equality, if it is in your opponent's favor, you are a fool, and if
in your own, you are unjust.
Precursor of the Random Walk Hypothesis
Slide 22
15.401
Louis Bachelier (18701946):

Thorie de la Spculation (1900)
First mathematical model of Brownian motion
Modelled warrant prices on Paris Bourse
Poincars evaluation of Bachelier:

The manner in which the candidate obtains the law of Gauss is most original, and all the
more interesting as the same reasoning might, with a few changes,be extended to the
theory of errors. He develops this in a chapter which might at first seem strange, for he
titles it ``Radiation of Probability''. In effect, the author resorts to a comparison with the
analytical theory of the propagation of heat. A little reflection shows that the analogy is
real and the comparison legitimate. Fourier's reasoning is applicable almost without
change to this problem, which is so different from that for which it had been created. It
is regrettable that [the author] did not develop this part of his thesis further.
Slide 23
15.401
Kruizenga (1956):
MIT Ph.D. Student (Samuelson)
Put and Call Options: A Theoretical and Market Analysis
Sprenkle (1961):
Yale Ph.D. student (Okun, Tobin)
Warrant Prices As Indicators of Expectations and Preferences
What Is The Value of Max [ ST K , 0 ]?
Assume probability law for ST
Calculate Et [ Max [ ST K , 0 ] ]
But what is its price?
Do risk preferences matter?
Slide 24
15.401
Samuelson (1965):
Rational Theory of Warrant Pricing
Appendix: A Free Boundary Problem for the Heat Equation Arising
from a Problem in Mathematical Economics, H.P. McKean
Samuelson and Merton (1969):
A Complete Model of Warrant Pricing that Maximizes Utility
Uses preferences to value expected payoff
Black and Scholes (1973):
Construct portfolio of options and stock
Eliminate market risk (appeal to CAPM)
Remaining risk is inconsequential (idiosyncratic)
Expected return given by CAPM (PDE)
Slide 25
15.401
Merton (1973):
Use continuous-time framework
Construct portfolio of options and stock
Eliminate market risk (dynamically)
Eliminate idiosyncratic risk (dynamically)
Zero payoff at maturity
No risk, zero payoff zero cost (otherwise arbitrage)
Same PDE
More importantly, a production process for derivatives!
Formed the basis of financial engineering and three distinct industries:
Listed options
OTC structured products
Credit derivatives
Slide 26
15.401
The Rest Is Financial History:
Photographs removed due to copyright restrictions.
Slide 27
Extensions and Qualifications
15.401
The derivatives pricing literature is HUGE

The mathematical tools involved can be quite challenging
Recent areas of innovation include:
Empirical methods in estimating option pricings
Non-parametric option-pricing models
Models of credit derivatives
Structured products with hedge funds as the underlying
New methods for managing the risks of derivatives
Quasi-Monte-Carlo methods for simulation estimators
Computational demands can be quite significant
This is considered rocket science
Slide 28
Key Points
15.401
Options have nonlinear payoffs, as diagrams show

Some options can be viewed as insurance contracts
Option strategies allow investors to take more sophisticated bets
Valuation is typically derived via arbitrage arguments (e.g., binomial)
Option-pricing models have a long and illustrious history
Slide 29
Additional References
15.401
Bachelier, L, 1900, Thorie de la Spculation, Annales de l'Ecole Normale Suprieure 3 (Paris,

Gauthier-Villars).
Black, F., 1989, How We Came Up with the Option Formula, Journal of Portfolio Management 15, 48.
Bernstein, P., 1993, Capital Ideas. New York: Free Press.
Black, F. and M. Scholes, 1973, The Pricing of Options and Corporate Liabilities, Journal of Political
Economy 81, 637659.
Kruizenga, R., 1956, Put and Call Options: A Theoretical and Market Analysis, unpublished Ph.D.
dissertation, MIT.
Merton, R., 1973, Rational Theory of Option Pricing, Bell Journal of Economics and Management
Science 4, 141183.
Samuelson, P., 1965, Rational Theory of Warrant Pricing, Industrial Management Review 6, 1331.
Samuelson, P. and R. Merton, 1969, A Complete Model of Warrant Pricing That Maximizes Utility,
Industrial Management Review 10, 1746.
Sprenkle, C., 1961, Warrant Prices As Indicators of Expectations and Preferences, Yale Economic
Essays 1, 178231.
Slide 30
MIT OpenCourseWare
http://ocw.mit.edu
15.401 Finance Theory I

Fall 2008
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15.

15.401 Finance Theory

Lecture 1011: Options

Derivative: Claim Whose Payoff is a Function of Another's

Lecture 1011: Options

Put Options As Insurance

Lecture 1011: Options

Lecture 1011: Options

Stock Return vs. Call Option Return

Lecture 1011: Options

Lecture 1011: Options

Lecture 1011: Options

Stock Price = S, Strike Price = X

Call option (price = C)

Put option (price = P)

Lecture 1011: Options

Lecture 1011: Options

Lecture 1011: Options

Buy call with

Write call with

Lecture 1011: Options

Buy call with

Buy put with

Lecture 1011: Options

Other Option-Like Securities

Equity: hold call, or protected levered put

Other Option-Like Securities

Other Examples of Derivative Securities:

Lecture 1011: Options

Binomial Option-Pricing Model of Cox, Ross, and Rubinstein (1979):

Lecture 1011: Options

Suppose S0 S1 Is A Bernoulli Trial:

Lecture 1011: Options

Now What Should C0 = f () Depend On?

Lecture 1011: Options

Now Choose and B So That:

* = (Cu Cd)/(u d)S0

Then It Must Follow That:

Lecture 1011: Options

Lecture 1011: Options

Note That p Does Not Appear Anywhere!

Continuous-time/continuous-state version (Black-Scholes/Merton):

Lecture 1011: Options

A Brief History of Option-Pricing Theory

Earliest Model of Asset Prices:

Lecture 1011: Options

A Brief History of Option-Pricing Theory

Louis Bachelier (18701946):

Poincars evaluation of Bachelier:

Lecture 1011: Options

A Brief History of Option-Pricing Theory

Lecture 1011: Options

A Brief History of Option-Pricing Theory

Lecture 1011: Options

A Brief History of Option-Pricing Theory

Lecture 1011: Options

A Brief History of Option-Pricing Theory

The Rest Is Financial History:

Photographs removed due to copyright restrictions.

Lecture 1011: Options

Extensions and Qualifications

The derivatives pricing literature is HUGE

Lecture 1011: Options