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Option pricing in a nutshell. Catley Lakeman Winter Offsite – January 2014. Introduction. 1 - Why are option pricing inputs inputs ? 2 - How these inputs affect the most purchased structures Accelerators Call spreads Digitals Autocalls 3 - Summary. Implied Volatility. Asset price.

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option pricing in a nutshell

Option pricing in a nutshell

Catley Lakeman Winter Offsite – January 2014

slide2

Introduction

  • 1 - Why are option pricing inputs inputs?
  • 2 - How these inputs affect the most purchased structures
    • Accelerators
    • Call spreads
    • Digitals
    • Autocalls
  • 3 - Summary
slide3

Implied Volatility

Asset price

Payoff = 20

Average = 10

120

Payoff = 10

Average = 5

110

100

Time

90

Payoff = 0

80

Payoff = 0

slide4

Time to Maturity

Asset price

Average = 10

Payoff = 20

120

Payoff = 10

Average = 5

110

100

Time

90

Payoff = 0

80

Payoff = 0

slide5

Interest Rates and Dividends

These affect the forward price.

The forward price of an asset is the price at which the hedger can sell the asset at a specified time in the future and expect to make or lose no money.

It is not the expected price of the asset at that point.

slide6

Interest Rates and Dividends

“I want to buy 1 ABC Plc Share from you in 1 year’s time. At what price will you sell it to me at that point?”

Market

Hedger

Investor

1: ABC Plc price = £1. Hedger borrows £1 from market and buys 1 share.

2: Over the year the hedger pays interest on loan (say 1%) and receives dividends on ABC Plc stock (say 3%).

Market

3: After 1 year hedger pays back the loan and sells the stock to client.

Hedger can sell the stock at 98p and still break even.

So 98p is the forward price.

slide8

Interest Rates and Dividends

December Future = 6513 points.

FTSE level = 6744 points.

Difference = 3.42%.

6513 is the “at the money forward” FTSE level.

This is the important level when pricing options, NOT the current spot level.

slide9

Interest Rates and Dividends

Asset price

Forward price

120

Payoff = 10

110

Average = 5

100

Time

Payoff = 0

90

80

slide10

Interest Rates and Dividends

Asset price

Forward price

120

Payoff = 15

110

Average = 7.5

100

Time

Payoff = 0

90

80

slide11

Recap

Higher vol = more chance of getting further away from strike.

More time = more chance of getting further away from strike.

Interest and dividends impact forward price.

slide16

MTM and the Greeks

Delta = sensitivity to asset price movement

Vega = sensitivity to volatility movement

Rho = sensitivity to interest rate movement

slide17

Summary

Time and volatility have a similar affect

Interest rates and dividends build the forward

We do this all the time!

slide20

DISCLAIMER

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley Lakeman Securities makes no guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without notice. This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended for the use of institutional and professional customers and is not intended for the use of private customers. This document is not intended for distribution in the United States of America or to US persons. This document is intended to be distributed in its entirety. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient.

Catley Lakeman Securities is a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. Registration

Number: OC336585, FSA Reference: 484826