Options

Guanglian Hu

S1, 2020

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 Applications

Option pricing models provide a nice framework to think about

various types of risk.

Option pricing models offer a benchmark to evaluate option returns

Option implied moments

Risk management

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Option implied volatility

Early measures of option implied volatility are based on inverting

option valuation formula. For example, one can invert the BSM
model to obtain an estimate of volatility.

Option implied volatility is forward-looking and reflects the market’s

expectation of future volatility of the underlying stock.

The state of art measure of option implied volatility exploits the fact
that implied volatility can be inferred from option prices in an
model-free way.

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The VIX Index

The VIX is a widely watched volatility index that measures the market’s
expectation of 30-day forward volatility implied from options market.
In 1993, the Chicago Board Options Exchange (CBOE) developed the
first-ever volatility index, which then was based on the average implied
volatility from at-the-money S&P 100 index options (VXO). The CBOE
provides a historical record of the VXO dating back to 1986.
In 2003, the CBOE changed the methodology used to construct the
volatility index and started publishing a new VIX index, which is calculated
as the weighted average of OTM S&P 500 option prices (VIX). The CBOE
provides a historical record of the VIX dating back to 1990.
Despite the difference in methodology, the two volatility indexes are very
similar (have a correlation about 0.99).

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VIX and VXO

160
VXO
140 VIX

120

100

80

60

40

20

0
1987 1990 1992 1995 1997 2000 2002 2005 2007 2010 2012 2015

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Volatility Risk Premium

The difference between realized variance and VIX2

200

150
100

50

-50

-100

1992 1995 1997 2000 2002 2005 2007 2010 2012 2015

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Volatility Risk Premium

Option implied volatility is higher than realized volatility on average.

The difference is called the volatility risk premium.

Volatility risk premium: investors dislike the fluctuations in volatility

and they are willing to pay a premium to buy assets that can hedge
an increase in volatility.

The volatility risk premium is a compensation for option writers who

provide insurance.

Trading on Volatility Risk Premium

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Option Implied Higher Moments and Distribution

Researchers soon realized that not only volatility, but other higher
moments (e.g., skewness and kurtosis) could be extracted from the
options market.

In fact, the entire risk neutral distribution can be inferred from option
prices.

The intuition is that the prices of Arrow-Debreu securities (AD), also

called state prices, can be inferred from option prices. Once we know
state prices, risk neutral probabilities can be easily calculated.

While this technique is more popular in the equity market, it can be

applied in any security with traded options.

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Option Implied Skewness and Kurtosis

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Option Implied Skewness and Kurtosis

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State Space Model
Suppose next period there are S states of the world (state of nature), which are
labeled by s, s = 1, 2, 3, ...S.

One of the most important frameworks for modeling investments under

uncertainty, also known as the time-state model of Arrow (1964) and Debreu
(1959)
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Risk Neutral Probabilities and State Prices
PS
State s occurs with probability πs , where 0 < πs < 1 and 1 πs = 1. [π1 ,
π2 , π3 ,...,πS ] are physical probabilities.
Consider Arrow-Debreu securities that pay off $1 if state of nature s occurs
next period and zero otherwise. Suppose we have one AD security for each
state of the world.
For example, the AD for state 1 will have a payoff vector

1
 
 0 
0
 
 
.
 
 
.
 
 
.
 
 
0
Let ws be today’s price of such claim. Basic arbitrage arguments dictate
that 0 < ws < 1. The prices of AD securities [w1 , w2 , w3 ,...,wS ] are also
referred to as state prices.
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Risk Neutral Probabilities and State Prices
Once we know the prices of Arrow Debreu securities, we will be able to price
any risky asset with a random payoff Y :
 
y1
 y2 
 .
 
Y = 
 .


yS

Note that the random payoff Y can be replicated by buying y1 units of AD

claim for state 1, y2 units of AD claim for state 2, y3 units of AD claim for
state 3.......
1 0 0
     
 0   1   0 
 0   0   0 
     

 .  + y2  .  + ..... + yS  . 
     
y1      
 .   .   . 
 .   .   . 
     

0 0 1
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Risk Neutral Probabilities and State Prices

The current price of Y , by arbitrage, must be given by adding up the values

of its component pieces:
X S
p= ws ys (1)
1

We can also use AD securities to infer the price of a risk-less bond (B) that
pay off $1 regardless of which state occurs.
S
X
B= ws
1

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Risk Neutral Probabilities and State Prices

Let
ws
π̃s = (2)
B

Note that π̃s have all of the properties of probabilities: 0 < π̃s < 1 and
S
1 π̃s = 1.
P

Observe from equation (2) and equation (1) on the previous slide, we can
rewrite the price of Y as
S S
X ws X
p=B ys = B π̃s ys
B
1 1

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Risk Neutral Probabilities and State Prices

Lastly, using B = 1
1 + rf , we have

S
1 X
p= π̃s ys
1 + rf
1

The value of a random cash flow Y is calculated as the expected value of

cash flow under the risk neutral probabilities, discounted by the risk-free
rate.

Note that
S
1 X
p 6= πs ys
1 + rf
1

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Risk Neutral Probabilities and State Prices: Summary

We consider the state space model of Arrow (1964) and Debreu

(1959) in which there exists a set of elementary contingent claims
(AD securities), each paying one dollar in one specific state of nature
and nothing in any other states.

In this set-up, we can break the payoffs or cash flows of any risky
asset down ’state-by-state’, and then pricing it as a bundle of AD
securities.

Risk neutral probabilities are state prices (the prices of AD securities)

dividend by the price of risk-free asset.

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Inferring State Prices From Option Prices

State prices can be inferred from prices of call options with different strikes.

Suppose the state of nature is summarized by the value of the market

portfolio which as a a discrete probability distribution with possible values
of: M = $1.00, $2.00, . . . , $N.

Denote the vector of payoffs of a European call option on the market with a
strike price of X as C(X); its price today will be denoted as c(X)

Market Portfolio C(0) C(1) C(2)

M=1 1 0 0
M=2 2 1 0
M=3 3 2 1
. . . .
. . . .
. . . .
M=N N N-1 N-2

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Inferring State Prices from Option Prices

The payoffs of AD securities can be replicated by combining call options on

the market portfolio with various strike prices.
For example, the claim having a payoff of $1.00 only if M(T) = $1 may be
constructed as [C(0) - C(1)] - [C(1) - C(2)]

1 0 1
     
 1   1   0 
 1   1   0 
     
 . − . = . 
     
 .   .   . 
     
 .   .   . 
     

1 1 0

In general, to replicate the claim giving $1 only if the market is M consists

of one long call with X =M-1,one long call with X=M+1, and two short
calls with X=M (if you recall, this is butterfly spread).

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Inferring State Prices from 0ption Prices: Example

For example, if N = 3 (only three states)

Suppose the prices of calls are c(0) = $1.7, c (1) = $0.8, and c (2) =
$0.1

Then the respective state prices are: P(M = 1) = $0.2, P(M = 2) =

$0.6, and P(M = 3) = $0.1

Also, the price of a riskless discount bond paying $1.00 would be $0.2
+ $0.6 + $0.1 = $0.9

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Risk Management

Just like other derivatives, options can be used to lock in future price
today and therefore they can be used to reduce the ”risk” or
”uncertainty”.

For example, an airline company can buy a call option on jet fuel to
hedge price fluctuations in jet fuel.

It is not clear whether companies should hedge in the first place. It is

hotly debated whether hedging can increase firm value.

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Risk Management

A long standing debate: Should firms engage in hedging

activities?

Yes, hedging creates value for a company.

reduce uncertainty / volatility of cashflows
lower financing costs
avoid underinvestment

No, hedging does not create value.

investors hold a well diversified portfolio and companies should not hedge
hedging can be costly and overweights the benefits

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