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Treasury Perspectives

Flaws with Black Scholes

& Exotic Greeks

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Flaws with Black Scholes & Exotic Greeks

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Flaws with Black Scholes & Exotic Greeks

Dear Readers:It’s been a difficult and volatile year for companies across the Globe. We have seen numerous risk management policies failures. To name a few... UBS, JPM Morgan, Libor manipulations by

European, US and Japanese banks and prominent accounting scandals like Lehman…

As rightly said by Albert Einstein “We can't solve problems by using the same kind of thinking we used when we created them.” and when you can't solve the problem, then manage it and don’t be dependent upon science as Science is always wrong, it never solves a problem without creating ten more.

The same is the case with Foreign Exchange Risk Management Policies (FXRM) which if can’t be managed properly then would lead to either systematic shocks or negative implications at the bottom line of the corporate, banks, FI and trading houses P&L A/cs.

That is something risk management struggles with, say the experts. In Richard Meyers’ estimation, risk managers or traders do not socialize enough. “It’s all about visibility,” he said.

Meyers, chairman and CEO of Richard Meyers & Associates, a talent acquisition and management firm in New Jersey, relates the story of a firm that decided to adopt an Enterprise

Risk Management (ERM) strategy. Instead of appointing its risk manager to head ERM, the company brought in someone else. Why?

Time has come when organizations across the world have to do deep amendments in their

Enterprise Risk Management (ERM) policies covering foreign exchange hedging programs, diversification in derivatives portfolio, Enterprise risk management policies and deeper and deeper understanding towards financial models.

With this background paper would like to appraise you on the “Flaws with Black Scholes &

Exotic Greeks” and take you through various Options strategies, Flaws, Greeks and appropriate thoughts towards the diversification in the derivatives portfolio.

Thanks You,

Rahul Magan

Author, Flaws with Black Scholes & Exotic Derivatives

LinkedIn- Rahulmagan8@gmail.com

Twitter: - Rahulmagan8

Face book: - Rahulmagan8@gmail.com

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Flaws with Black Scholes & Exotic Greeks

Flaws with Black Scholes Model (BSM) & Exotic Greeks

Rahul Magan

Sydney, Australia

ABSTRACT

In 1973, Fisher Black, Myron Scholes and separately Robert Merton derived the Black-ScholesMerton (BSM) model, which was rewarded the Nobel Prize in 1997. Despite its limitations, the model has survived until today as the dominant pricing model for standard and exotic

European style options.

The model owes its success to its simplicity, high intuition and versatility. In 1997, the importance of their model was recognized worldwide when Myron Scholes and Robert Merton received the Nobel Prize for Economics. Unfortunately, Fisher Black died in 1995, or he would have also received the award [Hull, 2000]. The Black-Scholes model displayed the importance that mathematics plays in the field of finance. It also led to the growth and success of the new field of mathematical finance or financial engineering.

This paper is all about flaws with Black Scholes and subsequent linkages with Exotic Greeks.

Directly Black Scholes is linked with six plain vanilla options Greeks and numerous exotics linked with each of these plain vanilla Greeks.

The paper is trying to establish relationship between plain vanilla and their linked exotics besides highlighting various thoughts on flaws with Black Scholes. As per author biggest flaw with Black Scholes is assumption of constant implied volatility & non applicability of principle of Skewness which is not true today due to huge monetization programs running by almost all central banks across the world. Such monetization programs would give rise to implied volatility and swan shocks and continue to stay for longer periods of time unless balance sheet deleveraging starts which do have its own positive and negative repercussions.

Paper also takes various references of plain vanilla Greeks, exotic Greeks, respective formulations and last but not the least effective hedging strategies. At respective point’s paper using various references pertaining to statistical data distributions like Normal Distribution,

Poisson distribution, Weibull Distribution and none the less Extreme value Theory (EVT) which in turn linked with swan events data shocks. Additional references are also taken to establish link between FX volatility w.r.t various markets parameters.

Key words: Black Scholes, Options derivatives, Exotic derivatives, Extreme Value Theory and

Statistical distributions.

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Flaws with Black Scholes & Exotic Greeks

Table of Contents

Part 1:Central banks monetization programs & Volatility in FX markets

(Topology of economic shocks & Mark to Market)

Page No 7

Part 1[A]: Option Structure and M2M hierarchy – US GaaP (FAS 157)

(Levels in M2M hierarchy)

Page No 10

Part 1[B]: Option Structures & Effectiveness

(Intrinsic & Extrinsic Valuation)

Page No 11

Part 2:Current assumptions with Black Scholes Model

(Nine most famous Black Scholes assumptions)

Page No 13

Part 3: Flaws with Black Scholes Model

(Four most famous Black Scholes flaws)

Page No 14

Part 4: Current Black Scholes Methodology

(Black Scholes & pricing mechanism)

Page No 16

Part 5: Delta vs. Dynamic Hedging

(Types of Delta Hedging & formula)

Page No 19

Part 6: Options Plain vanilla

(Description & understanding)

Page No 19

Part 7(A): Options Plain vanilla & exotic Greeks topology

(Options topology)

Page No 24

Part 7(B): Options Plain vanilla & exotic Greeks topology

(Formula & Derivations)

Page No 25

Part 8: Volatility Skewness & Frown

(Principle of Skewness)

Page No 29

Part 9: Options flaws with practical applicability

(Principle of Skewness)

Page No 31

Part 10: Conclusion

(Conclusion)

Page No 41

Part 11: About the author

(Professional & Social Networking)

Part 12: References & Citations

(References & linkups)

Part 13: Readers Feedback

(Technical Feedback)

Part 14: Notes

(Technical Notes)

Page No 42

Page No 43

Page No 44

Page No 45

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Flaws with Black Scholes & Exotic Greeks

Black Scholes abbreviations:BSM – Black Scholes Model

EVT – Extreme Value Theory

RR – Risk Reversals, Zero Cost Collar, Range Forwards, Fences, Cylindrical

LTFX – Long Term Foreign Exchange Hedging

Bfly – Butterfly Spreads

OM – Options Moneyness

ATM - At the money

ITM – In the money

OTM – Out of the money

Call/Put – Call option, Put option

ZCSP –Zero Coupon Swap Pricing

Statistical abbreviations:σx /σ – Standard Deviation σ2 – Variance

ND – Normal Distribution

RFIR – Risk free Interest rates

IV – Implied Volatility

US GaaP abbreviations:M2M – Mark to Market

M2M (L1/L2/L3) – M2M level hierarchy, US GaaP

Central banking abbreviations:FED – Federal Reserve

ECB – European Central Bank

BOJ – Bank of Japan

SNB – Swiss national Bank

ZIRP – Zero Interest Rate Policy

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Flaws with Black Scholes & Exotic Greeks

Part 1:- Central banks Monetization program & Volatility in FX markets

Today all cross currency exchange pairs are facing huge implied volatility due to excessive monetization program run by almost all central banks across the world. Due to this FX markets across the world are flush with huge USD liquidity which in turn creates either systematic economic or swan shocks.

Today Bank of Japan (BOJ) and Federal Reserve (FED) are linking their monetization programs with real time economic variables like Inflation and employment respectively. At present Fed holds the balance sheet size of over $ 4 Trillion and growing by ~ $ 1 Trillion/ Year which creates huge dollar liquidity in worldwide FX markets. European Central Bank (ECB) and Bank of Japan (BOJ) are holding almost same position when it comes to size of their balance sheets which are not only ballooning in nature but also growing in leaps and bounds.

With that level of implied volatility which is due to aforesaid reasons it is pertinent for

Treasurers to protect their bottom line from forecasted or non-forecasted FX risks, volatility and economic shocks. The present FX world is no more lead by normally distributed economic environment rather working under extreme value theory

(EVT) where in any sort of economic shocks or swan events are pretty common with periodic velocity.

These swan shocks can be further divided into four parts – White, Grey, Black and

Neon Swan events based upon ascending order of severity. Treasurers have to take conscious call and try and make sure that their derivatives portfolio won’t go in sudden gains/ (losses) because of sudden shift in economic variables due to swan shocks.

The aforesaid swan events can’t be covered or hedged by just creation of derivatives portfolio having plain vanilla forward contracts or Options (exotic or non-exotic).

Organizations have to have diversified their derivatives portfolio with deep level of understanding towards derivatives pricing models especially Black Scholes for Options

Pricing and Zero Coupon Swap Pricing (ZCSP) for LTFX hedging.

Today there is a high time when derivatives portfolio should appropriately diversified using options (plain vanilla or exotic Greeks) covering various assets classes. The days of zero currency volatility is gone henceforth plain vanilla derivatives are not effective.

Time has come when organizations have to have amended their risk management or foreign exchange hedging policies and make them in line with the markets else they are prone to huge M2M (Mark to Market) gains/ (losses) with even simplest white swan event/shock in the world.

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Flaws with Black Scholes & Exotic Greeks

Few glimpses on BOJ Monetization program:-

Relative size of the monetary base and

USD/JPY

Japan’s monetary base and CPI

Difference in balance sheet expansion and

USD/JPY

Source: - JP Morgan Research, IMF and WB research

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Flaws with Black Scholes & Exotic Greeks

Topology of Economic/ Systematic Shocks

Normally Distributed

Economic/ Systematic Shocks

Fat tail distributions (Fat tail) or Heavy tail distribution

Extreme Value Theory (EVT)

Economic / Systematic Shocks

Black Swan Event Theory

(Swan Events)

Neon Swan

Events

Mesokurtic distribution Leptokurtic distribution s

Platykurtic distribution Black Swan

Events

Grey Swan

Events

Kurtosis

Skewness

White Swan

Events

Principle of Skewness, Kurtosis & data distribution: Skewness tells you the amount and direction of skew (departure from horizontal symmetry), and kurtosis tells you how tall and sharp the central peak is, relative to a standard bell curve.

If Skewness is positive, the data are positively skewed or skewed right, meaning that the right tail of the distribution is longer than the left. If

Skewness is negative, the data are negatively skewed or skewed left, meaning that the left tail is longer.

If Skewness is less than −1 or greater than +1, the distribution is highly skewed. 9

Flaws with Black Scholes & Exotic Greeks

If Skewness is between −1 and −1/2 or between +1/2 and +1, the distribution is moderately skewed.

If Skewness is between −1/2 and +1/2 the distribution is approximately symmetric. Principle of Kurtosis & fat tail data distribution: Kurtosis is a measure of extreme observations. How likely will the returns be extreme, either positive or negative. Though the sign of Skewness is enough to tell us something about the data, kurtosis is often expressed relative to that of a normal distribution.

Data that has more kurtosis than the normal is sometimes called fat-tailed, because its extremes extend beyond that of the normal. By definition, and according to the formulas used, the kurtosis of a normal distribution is 3.0.

Fat-tailed distributions have values of Kurtosis that are greater than this.

Part 1[A]: Option Structure and M2M hierarchy – US GaaP (FAS 157)

Accounting world also facing big shifts in valuation methodologies especially M2M and derivatives standards. We have seen radical shifts in fair valuation and derivatives accounting standards like FAS 157 (Fair value principles) & FAS 133 (valuation of derivatives) in last couple of years. The M2M valuations cover all three types under

US GaaP FAS 157 “Fair Value Measurements”.

Level 1 input are quoted prices

(unadjusted) in active markets for identical assets or liabilities that

The reporting entity has the ability to access at the measurement date

US GaaP FAS 157

(Fair Value Measurements)

Level 2 inputs are inputs other than quoted Prices included within Level 1 that are observable for the asset or liability, either directly or indirectly through corroboration with observable

(market-corroborated

inputs) market data

Mark to Market (M2M)

Valuations

Mark to Market

(L1)

Mark to Model

(L3)

Mark to Matrix

(L2)

Level

3

inputs are unobservable inputs for the

Assets or liability, that is, inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or

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liability

Flaws with Black Scholes & Exotic Greeks

Part 1[B]: Option Structures & Effectiveness (Extrinsic / Intrinsic Valuation)

Options structures are amongst highly effective tools to hedge organizational forecasted cash flows, revaluations risks due to fair valuation of foreign currency assets and liability in balance sheets of respective legal entities and net investments hedge exposures

(intercompany loan from one legal entity to another.)

Options are also pretty cost effective in nature subject to risk management policies of corporate. Organizations have to take appropriate call whether to hedge their foreign currency cash flows in flows using zero cost collar, risk reversals or paid collars and subsequent amortization in there profit & loss segment.

Treasurers need to take conscious call whether to hedge their forecasted receivables or payables using plain vanilla forwards contracts, Options or exotic derivatives. There are millions of options exotic structures available to hedge your foreign exchange risk.

Options Strategies

(Pricing using Black Scholes)

Range Forwards/

Risk reversals /

Zero Cost Collars

Seagull (Buy

Call + Risk reversals) Call spreads

(Bullish/

Bearish)

Put Spreads

(Bullish /

Bearish)

Box/Condor/

Calendar

Spreads

Options Intrinsic Valuation (Option Moneyness)

This represents the amount of money, if any, that could currently be realized by exercising an option with a given strike price. For example, a call option has intrinsic value if its strike price is below the spot exchange rate. A put option has intrinsic value if its strike price is above the spot exchange rate.

In-The-Money: This term is applied to an option that has intrinsic value. That is when a profit can be realized upon exercising it. For a call option, it is the case when the spot

Exchange rate is higher than the strike price of the option, and for a put option, when the spot exchange rate is below the strike price.

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Flaws with Black Scholes & Exotic Greeks

Out-the-Money: A call option is said to be “out-of-the-money” if the underlying spot exchange rate is currently less than the strike price of the option. A put option is said to be “out-of-the-money” if the underlying spot exchange rate is currently more than the strike price of the option. An option that is “out-of-the-money” at expiry will have no value, and the holder of the option will allow it to expire worthless.

At-The-Money: This means that the strike price and the spot exchange rate are the same. Like the “out-of-the-money” option, the holder would allow the option to expire.

Options Extrinsic Valuation (Time Value)

Time value is a little more complex. When the price of a put or call option is greater than its intrinsic value, it is because the option has time value.

Time value is determined by: the spot price; the volatility of the underlying currency; the exercise price; the time to expiration; and the difference in the ‘risk-free’ rate of interest that can be earned by the two currencies. The time value of the option contract will diminish over the life of the option and at expiration will be zero.

The time value portion of an option is at its greatest when the option is “at-the-money:, that is the strike (exercise) rate is equal to the market rate. This is because the entire premium is equal to time value, as the option has no intrinsic value.

Options Fair value = Intrinsic Valuation + Extrinsic (Time value)

Options fair value is the sum of intrinsic valuation and extrinsic valuation or time value.

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Flaws with Black Scholes & Exotic Greeks

Part 2:- Current assumptions with Black Scholes Model

Exercise Timings. Options will be exercised in the European model, meaning no early exercise is possible. In fact, U.S. listed stocks are exercised in the

American model, meaning exercise may occur at any time prior to expiration.

This makes the original calculation inaccurate, since exercise is one of the key attributes of valuation.

Dividends. The underlying security does not pay a dividend. Today, many stocks pay dividends and, in fact, dividend yield is one of the major components of stock popularity and selection, and a feature affecting option pricing as well.

Calls but not puts. Modeling was based on analysis of call options values only.

At the time of publication, no public trading in puts was available. Once puts began to trade, the formula was again modified. However, if traders continue relying on the original BSM, even for put valuation, they may be missing a fundamental inaccuracy in the price attributes.

Taxes. Tax consequences of trading options are ignored or non-existent. In fact, option profits are taxed at both federal and state levels and this affects net outcome directly.

In some instances, holding the underlying over a one-year period may lead to short-term capital gains taxation due to the nature of options activity, for example. The exclusion of tax rules makes the model applicable as a pre-tax pricing model, but that is not realistic. In fairness to the model, everyone pays different tax rates combining federal and state, that any model has to assume pre-tax outcomes.

Transaction costs. No transaction costs apply to options trades. This is another feature affecting net value, since it’s impossible to escape the brokerage fees for both entry and exit into any trade.

This is a variable, of course; fee levels are all over the place and, making it even more complex, the actual options fee is reduces as the number of contracts traded rises. The model just ignored the entire question, but every trade knows that commissions can turn a marginally profitable trade into a net loss.

Unified Risk free Interest rates. A single interest rate may be applied to all transactions and borrowing; interest rates are unchanging and constant over the life span of the option. The interest component of B-S is troubling for both of these assumptions. Single interest rates do not apply to everyone, and the effective corresponding rates, risk-free or not, are changing continually.

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Flaws with Black Scholes & Exotic Greeks

Constant Implied Volatility (IV) Volatility remains constant over the life span of an option. Volatility is also a factor independent of the price of the underlying security. This is among the most troubling of the BSM assumptions.

Volatility changes daily, and often significantly, during the option life span.

It is not independent of the underlying and, in fact, implied volatility is related directly to historical volatility as a major component of its change.

Furthermore, as expiration approaches, volatility collapse makes the broad assumption even more inaccurate.

Trading is continuous. Trading in the underlying security is continuous and contains no price gaps. Every trader recognizes that price gaps are a fact of life and occur frequently between sessions.

It would be difficult to find a price chart that did not contain many common gaps. It is understandable that in order to make the pricing model work, this assumption was necessary as a starting point. But the unrealistic assumption further points out the flaws in the model.

Price movement is normally distributed. Price changes in the short term in the underlying security are normally distributed. This statistical assumption is based on averages and the behavior of price; but studies demonstrate that the assumption is wrong. It is one version of the random walk theory, stating that all price movement is random.

Influences like earnings surprises, merger rumors, and sector, economic and political news, all affect price in a very non-random manner. The stock price process in the Black-Scholes model is lognormal, that is, given the price at any time, the logarithm of the price at a later time is normally distributed. It is also known how to do option pricing for a continuous-time model with normally distributed prices, but the lognormal model is more reasonable because stocks have limited liability and cannot go negative.

Part 3: Flaws with Black Scholes Model

Exercise Timings. Black Scholes model should consider all three possible exercise timings scenarios using options– European, American and Bermudian.

This would help traders to price options in a better way considering reversal of trades at favorable fair valuation in live markets.

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Flaws with Black Scholes & Exotic Greeks

Today majority of the traders are keeping options in their derivatives portfolio under Available for Sale (AFS) or Held for Trading (HFT) categories hence forth they prefer American over European options.

The former can be realized any moment depends upon intrinsic & extrinsic valuation of the options however later might not be unless subject to reversal or cancellation.

There are hardly any traders left who keep Options as an derivative under

Held till Maturity (HTM) hence forth restriction towards exercise timings is all flawed w.r.t current market structure.

Unified Risk free Interest rates (RFIR). There is no single index or any G sec bond which can act as a risk free interest rate for all FX pricing models.

All G7 currencies are having their respective risk free interest rates hence forth no single interest rate can act as a universal risk free interest rate for respective currency pairs. As of now UST (United States Treasuries) yields are acting as unified interest rates to price any USD denominated options w.r.t G7 currencies where in USD is acting as base or termed currency. Central banks are doing huge monetization along with maintenance of zero interest rates policy (ZIRP) for both shorter and longer period of debt portfolio. Considering that there should be multiple rates for multiple periods to do options valuations for respective currency pairs.

Constant Implied Volatility Implied, Historical and realized volatility can never be constant as it keeps changing. That change depends upon level of shocks in FX markets across the world as volatility is a Meta measure.

Any volatility measure can’t be constant for longer tenors hence forth options pricing models should consider moving or ranged volatility to price contracts. Black Scholes should also have ranged volatility as an input variable to price contracts in a better way.

Traders have to decide whether they would like to go with implied, realized, historical volatility (with or without outliers) or statistical volatility. There is a great probable chance that Traders would use statistical volatility which is further derived using statistical data distributions.

It may or might not have any outliers and all depends upon input valuation parameters taken by traders along with current valuation of stocks or currency pair in respective markets.

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Flaws with Black Scholes & Exotic Greeks

Price movement is normally distributed We are living in the world of

“Extreme Value Theory(EVT)” where in FX markets are always suspect to any kinds of swan events like white, grey, black and neon swan events.

Implied volatility can go either ways depends upon the shocks and their resistance. There are various technical or fundamental indictors available to assess the valuation of these black swan events but these indicators nowhere support any form of normal distribution.

Extreme value theory deals with the stochastic behavior of the extreme values in a process. For a single process, the behavior of the maxima can be described by the three extreme value distributions–Gumbel, Fr´echet and negative Weibull–as suggested by Fisher and Tippett (1928).

The key to EVT is extreme value theory which a cousin of better known central limit theorem which tells us what distribution of extreme value should look like in the limit as our sample size increases. Extreme value theory or extreme value analysis (EVA) is a branch of statistics dealing with the extreme deviations from the median of probability distributions.

It seeks to assess, from a given ordered sample of a given random variable, the probability of events that are more extreme than any previously observed.

In probability theory and statistics, the generalized extreme value (GEV) distribution is a family of continuous probability distributions developed within extreme value theory to combine the Gumbel, Fréchet and Weibull families also known as type I, II and III extreme value distributions. By the extreme value theorem the GEV distribution is the limit distribution of properly normalized maxima of a sequence of independent and identically distributed random variables. Because of this, the GEV distribution is used as an approximation to model the maxima of long (finite) sequences of random variables.

Part 4: Current methodology of Black Scholes

The Black-Scholes formula can be derived as the limit of the binomial pricing formula as the time between trades shrinks, or directly in the continuous time model using an arbitrage argument. The option value is a function of the stock price and time, and the local movement in the stock price can be computed using a result called It^o's lemma, which is an extension of the chain rule from calculus. Once It^o's lemma is used to calculate the local change in the option value in term of derivatives of the function of stock price and time, absence of arbitrage implies a restriction on the derivatives of the function (in economic terms, risk premium is proportional to risk exposure), essentially similar to the per-period hedge in the binomial model.

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Flaws with Black Scholes & Exotic Greeks

The two terms in Black-Scholes call formula are prices of digital options. The term SN(x1) is the price of a digital option that pays one share of stock at maturity when the stock price exceeds X: this is a digital option if we measure in terms of the stock price (this is called using the stock as numeraire and is like a currency conversion).

The second term XN(x2) is the price of a short position in a digital option that pays X at maturity when the stock price exceeds X. There is a slightly mystical result that the two terms also represent the portfolio we hold to replicate the option if we want to create the call option at the end by holding SN(x1) long in stocks and BN(x2) short in bonds (with trading to vary this continuously as time passes and the stock price evolves).

Option traders call the formula they use the “Black-Scholes-Merton” formula without being aware that by some irony, of all the possible options formulas that have been produced in the past century is the one the furthest away from what they are using. In fact of the formulas written down in a long history it is the only formula that is fragile to jumps and tail events.

The Black-Scholes-Merton argument, simply, is that an option can be hedged using a certain methodology called “dynamic hedging” and then turned into a risk-free instrument, as the portfolio would no longer be stochastic.

The Black-Scholes-Merton argument and equation flow a top-down general equilibrium theory, built upon the assumptions of operators working in full knowledge of the probability distribution of future addition to a collection of assumptions that, we will see, are highly invalid mathematically, the main one being the ability to cut the risks using continuous trading which only works in the very narrowly special case of thin-tailed distributions.

But it is not just these flaws that make it inapplicable: option traders do not “buy theories”, particularly speculative general equilibrium ones, which they find too risky for them and extremely lacking in standards of reliability.

A normative theory is, simply, not good for decision-making under uncertainty (particularly if it is in chronic disagreement with empirical evidence). People may take decisions based on speculative theories, but avoid the fragility of theories in running their risks. This discussion will present our real-world; ecological understanding of option pricing and hedging based on what option traders actually do and did for more than a hundred years. This is a very general problem.

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Flaws with Black Scholes & Exotic Greeks

There should not be unified risk free interest rates to price options in various cross currency pairs.

There should not be constant implied volatility to price options in various cross currency pairs.

FX markets are following EVT than any form of normal distribution. 18

Flaws with Black Scholes & Exotic Greeks

Part 5: Delta vs. Dynamic Hedging

Delta Hedging In this form of hedging traders tries to neutralize the portfolio delta w.r.t movement in the underlying price almost on daily basis. The size of the derivatives portfolio is so large that even 10 Bps shift (II shift or non II shift) would lead to windfall gains or losses hence forth almost daily intervention is required. Absolute movement in underlying vs. delta

Relative movement in underlying vs. delta - Delta or Gamma Cash

Elasticity of the Options ( applicable for both puts and calls )

Dynamic hedging In this form of hedging traders tries to neutralize the change in portfolio valuation on or at specific period of times vs. on daily basis in case of delta hedging. The difference b/w Delta neutral and dynamic hedging is former is done almost on almost daily basis while later is done at periodic intervals

(unless huge movements in FX markets).

Part 6: Options Plain Vanilla Greeks

Options

Payoffs

Delta

Gamma

Theta

Vega

Rho

Long Call

Short Call

Long Put

Short Put

+Ve

-Ve

-Ve

+Ve

+Ve

-Ve

+Ve

-Ve

-Ve

+Ve

-Ve

+Ve

+Ve

-Ve

+Ve

-Ve

+Ve

-Ve

-Ve

+Ve

Delta Greek - Delta is the option's sensitivity to small changes in the underlying asset price. Delta is positive for calls and negative for puts. For a vanilla option, delta will be a number between 0.0 and 1.0 for a long call (and/or short put) and

0.0 and −1.0 for a long put (and/or short call) – depending on price, a call option behaves as if one owns 1 share of the underlying stock (if deep in the money), or owns nothing (if far out of the money), or something in between, and conversely for a put option.

The difference of the delta of a call and the delta of a put at the same strike is close to but not in general equal to one, but instead is equal to the inverse of the discount factor. By put–call parity, long a call and short a put equals a forward F, which is linear in the spot S, with factor the inverse of the discount factor, so the derivative dF/dS is this factor.

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Flaws with Black Scholes & Exotic Greeks

The sign and percentage are often dropped – the sign is implicit in the option type (negative for put, positive for call) and the percentage is understood. The most commonly quoted are 25 Delta put, 50 Delta put/50

Delta call, and 25 Delta call. 50 Delta put and 50 Delta call are not quite identical, due to spot and forward differing by the discount factor, but they are often conflated. Delta is always positive for long calls and negative for long puts (unless they are zero).

The total delta of a complex portfolio of positions on the same underlying asset can be calculated by simply taking the sum of the deltas for each individual position – delta of a portfolio is linear in the constituents. Since the delta of underlying asset is always 1.0, the trader could delta-hedge his entire position in the underlying by buying or shorting the number of shares indicated by the total delta.

For example, if the delta of a portfolio of options in XYZ (expressed as shares of the underlying) is +2.75, the trader would be able to delta-hedge the portfolio by selling short 2.75 shares of the underlying. This portfolio will then retain its total value regardless of which direction the price of

XYZ moves.

Gamma Greek - Gamma is the delta's sensitivity to small changes in the underlying asset price. Gamma is identical for put and call options. Gamma, measures the rate of change in the delta with respect to changes in the underlying price. Gamma is the second derivative of the value function with respect to the underlying price. All long options have positive gamma and all short options have negative gamma. Gamma is greatest approximately at-the-

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Flaws with Black Scholes & Exotic Greeks

money (ATM) and diminishes the further out you go either in-the-money (ITM) or out-of-the-money (OTM).

Gamma is important because it corrects for the convexity of value.

When a trader seeks to establish an effective delta-hedge for a portfolio, the trader may also seek to neutralize the portfolio's gamma, as this will ensure that the hedge will be effective over a wider range of underlying price movements. However, in neutralizing the gamma of a portfolio, alpha (the return in excess of the risk-free rate) is reduced. Vega Greek - Vega is the option's sensitivity to a small change in the volatility of the underlying asset. Vega is identical for put and call options. Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of the underlying asset. Vega is not the name of any Greek letter. However, the glyph used is the Greek letter .

Presumably the name Vega was adopted because the Greek letter nu looked like a Latin vee, and Vega was derived from vee by analogy with how beta, eta, and theta are pronounced in English. The symbol kappa, is sometimes used (by academics) instead of Vega (as is tau ( ), though this is rare).

Vega is typically expressed as the amount of money per underlying share that the option's value will gain or lose as volatility rises or falls by 1%. Vega can be an important Greek to monitor for an option trader, especially in volatile markets, since the value of some option strategies can be particularly sensitive to changes in volatility. The value of an

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Flaws with Black Scholes & Exotic Greeks

option straddle, for example, is extremely dependent on changes to volatility. Theta Greek - Theta is the option's sensitivity to a small change in time to maturity. As time to maturity decreases, it is common to express theta as minus the partial derivative with respect to time. Theta , measures the sensitivity of the value of the derivative to the passage of time (see Option time value): the

"time decay." Theta is almost always negative for long calls and puts and positive for short (or written) calls and puts. An exception is a deep in-themoney European put. The total theta for a portfolio of options can be determined by summing the thetas for each individual position.

The value of an option can be analyzed into two parts: the intrinsic value and the time value or extrinsic value. The intrinsic value is the amount of money you would gain if you exercised the option immediately, so a call with strike $50 on a stock with price $60 would have intrinsic value of $10, whereas the corresponding put would have zero intrinsic value. The time value or extrinsic value is the value of having the option of waiting longer before deciding to exercise.

22

Flaws with Black Scholes & Exotic Greeks

Rho Greek - Rho is the option's sensitivity to small changes in the risk-free interest rate. Rho, measures sensitivity to the interest rate: it is the derivative of the option value with respect to the risk free interest rate (for the relevant outstanding term). Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest rate than to changes in other parameters. For this reason, rho is the least used of the first-order Greeks. Rho is typically expressed as the amount of money, per share of the underlying, that the value of the option will gain or lose as the risk free interest rate rises or falls by

1.0% per annum (100 basis points).

Greeks Linkup:-

23

Flaws with Black Scholes & Exotic Greeks

Part 7: Topology of plain vanilla & exotic options Greeks

Topology of Plain Vanilla and

Exotic Option Greeks

Delta Greek

Gamma Greek

Theta Greek

DdeltaDvol,

Dvega Dspot,

DvannaDvol,

DdeltaDtime

(Charm)

DgammaDvol,

Zomma,

DgammaDspot,

Speed,

DgammaDtime,

Color

Drift less Theta,

Bleed-Offset

Volatility, Theta

Gamma Greek

Vega Greek

DvegaDvol

(Vomma),

DvommaDvol

(Ultima),

DvegaDtime,

DdeltaDvar

Phi/Rho/ carry

Rho

Volatility in local or foreign currency interest rates w.r.t underlying Dzeta Dvol = Zeta sensitivity/Implied Volatility

DzetaDtime = In the money risk neutral volatility/

Theta

Implied volatility plays a critical role in valuation of all exotic Greeks.

ITM

ATM

OTM

24

Flaws with Black Scholes & Exotic Greeks

Part 7(B): Plain vanilla & exotic options Greeks – Formula & Derivations

Exotic Greeks on Delta (DdeltaDvol):- DdeltaDvol is mathematically the same as Dvega- Dspot, defined as (aka vanna). They both measure approximately how much delta will change due to a small change in the volatility, and how much

Vega will change due to a small change in the asset price where n(x) is the standard normal density

Assumption of constant implied volatility is amongst the biggest flaws with Black Scholes henceforth any Greek having delta as a numerator and implied volatility as a denominator would never be able to act as a right measure in pricing options contracts.

Delta in itself is a measure of change in option price to change in underlying and change in underlying is 100% linked with principle of

Skewness hence forth DdeltaDvol would not act as a right measure.

Principle of Skewness suggests that options with lower strike would have high implied volatility and options with higher strike price are having low implied volatility. The same would act vice versa in case of any swan events. Alternatively traders have to define whether they would like to go with ATM, ITM or OTM implied volatility.

DdeltaDvol = Change in Delta / Change in Implied Volatility

Delta = Change in option price / change in underlying

25

Flaws with Black Scholes & Exotic Greeks

Exotic Greeks on Delta (DvannaDvol):- The second-order partial derivative of delta with respect to volatility, also known as DvannaDvol.

This exotic Greek is about change in Gamma w.r.t to change in implied volatility. Gamma is nothing but second order partial derivative for delta.

Gamma considers all nonlinear movements in delta and with the assumption of constant implied volatility this exotic Greek won’t work.

DvannaDvol = Change in Gamma/ Change in Implied Volatility

Gamma = Change in Delta / Change in Underlying

Exotic Greeks on Delta (DdeltatDtime, Charm):- DdeltatDtime, also known as charm or Delta Bleed, a term used in the excellent book by Taleb (1997), measures the sensitivity of delta to changes in time. This Greek indicates what happens with delta when we move closer to maturity.

The exotic Greek is about change in delta w.r.t change in theta. Theta supports the writers in options as with the decrease in the time value there would be support to option writers.

26

Flaws with Black Scholes & Exotic Greeks

Exotic Greeks on Gamma (DgammaDvol):- DgammaDvol (aka zomma) is the sensitivity of gamma with respect to changes in implied volatility. DgammaDvol is in my view one of the more important Greeks for options trading.

The exotic Greek is about change in Gamma / Change in Implied Volatility.

Gamma is second order derivatives of Delta and delta is change in option price w.r.t to change in underlying.

Zomma= Change in Gamma/Change in Implied Volatility

Gamma = Change in Delta/ Change in underlying

Delta = Change in option price / change in underlying

27

Flaws with Black Scholes & Exotic Greeks

Exotic Greeks on Gamma (DgammaDspot):- The third derivative of the option price with respect to spot is known as speed. Speed was probably first mentioned by Garman (1992).

The exotic Greek is about change in Gamma w.r.t to change in spot price of the exchange pair. Gamma is the second order partial derivative of the delta which is change in delta to change in underlying

This Greek would tell you the non linear impact of the change in spot

w.r.t Gamma. Change in spot is always linked with principle of skewness which is “change in spot is always linked with sudden change in volatility for near, medium or far terms for both put and call options.

Exotic Greeks on Gamma (DgammaDtime):- The change in gamma with respect to small changes in time to maturity, DGammaDtime—also called Gamma

Theta or color (Garman, 1992)—is given by (assuming we get closer to maturity)

28

Flaws with Black Scholes & Exotic Greeks

Part 8: Volatility Skew & Frown

Volatility Skew/Frown / Principle of Skewness:The Black and Scholes assume that volatility is constant. This is at odds with what happens in the market where traders know that the formula misprices deep in-the-money and deep out-the-money options.

The mispricing is rectified when options (on the same underlying with the same expiry date) with different strike prices trade at different volatilities - traders say volatilities are skewed when options of a given asset trade at increasing or decreasing levels of implied volatility as you move through the strikes.

The empirical relation between implied volatilities and exercise prices is known as the “volatility skew”. The volatility skew can be represented graphically in 2 dimensions (strike versus volatility).

The volatility skew illustrates that implied volatility is higher as put options go deeper in the money. This leads to the formation of a curve sloping downward to the right

The implied volatility is the one which when input into the BlackScholes option pricing formulae gives the market price of the option.

It is often described as the market’s view of the future actual volatility over the lifetime of the particular option.

The actual volatility is very difficult to measure and can be thought of as the amount of randomness in an asset return at any particular time.

29

Flaws with Black Scholes & Exotic Greeks

If we take options with the same maturity on a certain foreign currency that varies only in strike price we can calculate the implied volatility for each one.

Keep in mind that since they share the same underlying asset we expect the volatility to remain constant regardless of the strike price.

The volatility is relatively low for at-the-money options and gets progressively higher as an option moves either into or out of the money. We gain some analytical insight into why this occurs if we compare the implied volatility distribution with the lognormal one with the same mean and standard deviation.

Consider a deep out-of-the-money call with strike price above K2. This derivative will only pay off if the exchange rate closes above K2, and according to the above figure the probability of this happening is higher for the implied distribution than the lognormal one.

A higher probability will generate a higher price, which in turn means a higher implied volatility. The same is true of a deep out-of-themoney put with strike price below K1.

30

Flaws with Black Scholes & Exotic Greeks

Part 9: Options flaws / limitations vs. Practical applicability

Exercise Timings. Black Scholes model should consider all three possible exercise timings scenarios using options– European, American and Bermudian.

This would help traders to price options in a better way considering reversal of trades at favorable fair valuation in live markets.

Today majority of the traders are keeping options in their derivatives portfolio under Available for Sale (AFS) or Held for Trading (HFT) categories hence forth they prefer American over European options.

The former can be realized any moment depends upon intrinsic & extrinsic valuation of the options however later might not be unless subject to reversal or cancellation which is further subject to risk management policies and effective implementation.

There are hardly any traders left who keep Options as an derivative under Held till Maturity (HTM) hence forth restriction towards exercise timings is all flawed w.r.t current market structure. The below chartings taken from Reuters which clearly indicate the real time Greeks,

Implied Volatility and Zero Coupon Swap pricing (ZCSP).

In American Options traders are having right to reverse the trade any time depends upon options fair value which is nothing sum of Intrinsic and Extrinsic value.

American Options can be reversed using 10 Delta to ATM or till 100 Delta and all depends upon the levels of Delta and Gamma trading in the market. These options can also be trade w.r.t to volatility trading in the markets. 10 D

ATM

Zero Deltas to ATM is considered as OTM trade.

100 D

ATM Delta to 100 Delta is considered as ITM trade.

Chart 1: - USD American Put in OTC Markets with plain vanilla Greeks

The below chart depicts the valuation methodology of American Put along with its plain vanilla Greeks. The same is not possible in European Put options because trades are unable to reverse their trades.

31

Flaws with Black Scholes & Exotic Greeks

In European trades you have to wait till the maturity dates to get it realized and park realized gains/ (losses) in profit & loss a/c which hit bottom line for the organization.

The below chart also shares 5 plain vanilla Greeks like Delta, Gamma,

Theta, Vega, Rho and extended Greeks like 7 Days Theta, break-even price and break-even delta which hold no value in case of European put options.

Input variables for

American OTC Put

Options Greeks – From

Delta to Break even delta

Chart 2: - Realized Volatility of USD American Put in OTC Markets with IV

The below charts depicts two years full range volatility for Euro along with historical volatilities for one, two, three and six months.

32

Flaws with Black Scholes & Exotic Greeks

The charts also shares realized volatility pertaining to ATM Bid/Ask,

25 D RR, 25 Bfly, and 10 D RR for Euro/USD currency pairs. The same charts also shares ATM volatility pertaining to Eur/USD, USD/JPY,

USD/CHF and other G7 currency pairs.

It is apparent that volatility keeps changing on daily basis hence and if we link this with “Principle of Option Skewness” then the change in implied volatility would have impact on the strike price of the options. The change in strike price due to change in implied volatility change implied options fair valuation as well.

Periodic Volatility and full range volatility

Principle of Options

Skewness – Options strike price changes with change in Implied

Volatility.

33

Flaws with Black Scholes & Exotic Greeks

Options ATM to 10 Bfly volatility ATM volatility for G7 currency pairs – SW

(Spot Week) till

1 Yr

Constant Implied Volatility Implied, Historical and realized volatility can never be constant as it keeps changing. That change depends upon level of shocks in FX markets across the world as volatility is a Meta measure.

Any volatility measure can’t be constant for longer tenors hence forth options pricing models should consider moving or ranged volatility to price contracts. Black Scholes should also have ranged volatility as an input variable to price contracts in a better way.

Traders have to decide whether they would like to go with implied, realized, historical volatility (with or without outliers) or statistical volatility. 34

Flaws with Black Scholes & Exotic Greeks

There is a great probable chance that Traders would use statistical volatility which is further derived using statistical data distributions.

It may or might not have any outliers and all depends upon input valuation parameters taken by traders along with current valuation of stocks or currency pair in respective markets.

Chart 3: Eur/ USD Options Implied Volatility & Risk Reversals

The chart depicts the various volatility surfaces for Eur/USD from ATM till

25 D RR. It also shares the volatility surfaces for Eur/USD Butterfly spreads. The chart also shares volatility surfaces from SW (Spot Week) to 10 YRR

(10 Years Risk Reversals) for both Bid/Ask spreads. This volatility can be used to price options using Black Scholes for various maturities periods.

This volatility can also be used to price various option strategies like risk reversals, zero cost collars, fences, call and put spreads (bullish or bearish strategies) and Seagulls.

Eur/USD 10% Delta

RR from SW to 10 Yr

Eur/USD Bfly spreads from SW to 10 Yr

35

Flaws with Black Scholes & Exotic Greeks

Chart 4: Option FX, Volatility Matrix and Volatility surfaces

The chart depicts about FX vols, ATM FX Vols, FX Smiles and volatility surfaces for Euro USD. These charts clearly depicts that volatility can’t be constant as it keeps moving in either ways. This is amongst most fundamental flaws in BSM regarding options pricing.

The charts depicts various charts indicating implied/ATM volatility, realized volatility, underlying spot rate and spreads b/w (realized and implied volatility) from Q1’12 – Q2’13.

Composite

Volatility from

SW till 10 Yr

Implied ATM Vol,

Realized Vol,

Underlying spot rate and spreads

36

Flaws with Black Scholes & Exotic Greeks

Chart 5: Option FX, Volatility Matrix and Volatility surfaces

The chart depicts the volatility curves b/w real time ATM and Historical

ATM. It clearly states that the assumption of either constant or no ranged volatility is wrong and gives you no realistic call and put prices. These prices are subject to M2M even with the simplest swan shock and lead to huge M2M gains/ (losses) in profit & loss a/c.

Real time vs.

Historical ATM vols Historical vs. real time Implied volatility 37

Flaws with Black Scholes & Exotic Greeks

Chart 6: G7 volatility matrix

The chart depicts volatility matrix for following G7 currencies covering below currencies

Commodities pairs: AUS/USD, USD/CAD, NZD/USD

G7 Cross Currencies pairs: USD/JPY, GBP/USD, USD/CHF, USD/CZK, EUR/USD, GBP/EUR,

GBP/AUD and GBP/EUR

Most volatility currency pairs: EUR/USD, USD/JPY, USD/INR, GBP/AUD, EUR/AUD

Cross currency

Volatility

Matrix

38

Flaws with Black Scholes & Exotic Greeks

Unified Risk free Interest rates (RFIR). There is no single index or any G sec bond which can act as a risk free interest rate for all FX pricing models.

Chart 7: USDOIS & INRIRS as interest rates

The below charts depicts the interbank interest rates for USD OIS and

INRIRS. The period selected for USDOIS is SW (Spot week) till2 Yrs and for

INRIRS is from 1 Yrs till 10 Yrs.

USDOIS Interest rates from SW till 2 Yrs.

INRIRS Interest rates from 1Yrs till 10 Yrs to price swaps in various currency pairs.

39

Flaws with Black Scholes & Exotic Greeks

Chart 8: USD Interest rates (LIBOR – OIS)

The below charts depicts the Interest rates pertaining to USD from LIBOR to OIS. The chart also shares FRA (Forwards Rate Agreements) rates from

0x3 till 9X12 periods.

It also shares Basis swaps interest rates from 1 Yrs till 10 Yrs on basis.

Basis swaps are the swaps where in both the parties pay floating rate interest rates.

Interest rates from Libor - OIS

40

Flaws with Black Scholes & Exotic Greeks

Part 10: Conclusion of the paper

Throughout the paper we discussed multiple strategic flaws with current methodology of Black Scholes. The present methodology is having deep impact on the

FX markets although unnoticed by traders and regulators every time. These methodologies require deeper amendments because of huge and tactical shift in implied volatility structures in today FX markets which is far more structural than pre or post cyclical in nature.

Financial terminals like Reuters and Bloomberg should also need to amend their current methodologies regarding fixing of various Interest rates which further acts as benchmarks for pricing of cross currency swaps for respective currencies pairs. These formula-based pricing assumptions rest on the belief under BSM that a risk-free interest rate is available and, furthermore, that it applies to everyone and remains unchanged. These assumptions are untrue. Consequently, a user of such terminals may not rely on outcomes without the ability to adjust the assumptions to suit their individual needs.

Black Scholes should have added tenured interest rates (may or might not be risk free) and ranged volatility (excluding or including outliers) as input variables to leverage its valuation methodology with markets.

Corporates are also diversifying their derivatives portfolio by adding options for various maturities periods and make their risk management policies in line with recent developments in markets. Corporates need strategic shift from plain vanilla derivatives contracts like forwards to options for both longer and shorter versions of the hedging tenor.

World FX markets are facing periodic swan events hence forth we need strong resolutions to fix these structural issues which are yet to be resolved. The time has come to either amend these obsolete assumptions or make a shift to live with updated pricing model having better assumptions.

41

Flaws with Black Scholes & Exotic Greeks

Part No 11: About the author

Professional Front:At present author is working as Manager Treasury - Front & Middle Office - FX,

Derivatives, ISDA & Global Investments in EXL Service. He holds ~ 6 Yrs of work experience in corporate treasuries of top Indian IT & ITES companies like HCL

Technologies Limited and presently with EXL Service.com (I) Pvt. Ltd.

Author holds well diversified experience in respective functions of Front Office of corporate Treasuries:

Foreign Exchange Hedging - Cash Flow & Fair Value Hedging Program

Offshore & Onshore Treasury Risk Management

National & International Treasury compliances - RBI, SEC and FSA

End to End Designing of Treasury Management Systems – SAP & Oracle

Global investments managements & trapped cash funding

ISDA compliances , Dodd Frank

Social Networking Front:Author is pretty active on LinkedIn and holds networking base of over 35 Million professionals across the world. He also actively participates in various issues pertaining to FX, derivatives, macro & micro prudential and structural issues with eminent professionals across the world. His participation is with over 100 top and eminent

LinkedIn Groups.

LinkedIn nominated his profile amongst top 1% for three years in a row (20092012).He holds his own FX Group –“Foreign Exchange Maverick Thinkers” and also acting as manager for “Italian Options Traders” having membership base of +530 &

+800 members respectively.

Foreign Exchange Maverick Thinkers:The Group dedicates to all those who not only think but also acts different in Foreign

Exchange markets. The current membership stands over 530 which includes International

FX Brokers, Italian & Australian Options Traders, International Business consultants,

Worldwide Investments Bankers, FX Research heads of various eminent Financial

Institutions, Worldwide Foreign Exchange consultants & Trainers, Chicago Mercantile

Exchange Traders (CME ), International Govt. Budgeting bodies, Central banks members and last but not the least Corporate Treasurers of various International big corporate working across the Globe.

42

Flaws with Black Scholes & Exotic Greeks

Part No 12: References & Citations

Reference Source:FX Manuals

JP Morgan Research

IMF/WB/IFC

Option pricing formulas

FX Charts

Greek Charts

Reference Type

Option Greeks

Thoughts on Macro prudential & monetization programs

Charts on BOJ monetization programs

Central banks monetization data and balance sheets

The complete guide to Option Pricing formulas , Espen Gaarder

Haug

Reuters EIKON

Numerous FX & derivatives books

Citation on ThomsettOptions.com:ThomsettOptions.com is an options educational site. Author Michael C. Thomsett has published many books about options, including the best-selling Getting Started in

Options (John Wiley & Sons, currently in its 9th edition and with over 250,000 copies sold). On this website, the author presents daily free articles about options topics, notably on the problems of relying on Black Scholes. He also operates a virtual portfolio for members, in which he transactions options-based trades using real-time stock and option values, for the purpose of demonstrated how a range of different options trades works and the rationale for entry and exit. The site also publishes a free weekly newsletter. Thomsett also posts daily articles on LinkedIn groups, and belongs to 560 groups including Foreign Exchange Maverick Thinkers where he became associated with Rahul Magan.

43

Flaws with Black Scholes & Exotic Greeks

Part 13: Readers Feedback

Dear Reader – You are most welcome to share your feedback in technical context at below given details.

Email: - Rahulmagan8@gmail.com/ Rahulmagan80@gmail.com

Handheld: 91 -9899242978/9868281769

LinkedIn- Rahulmagan8@gmail.com

Twitter: - Rahulmagan8

Face book: - Rahulmagan8@gmail.com

44

Flaws with Black Scholes & Exotic Greeks

Notes:-

45

Flaws with Black Scholes & Exotic Greeks

Notes:-

46

Flaws with Black Scholes & Exotic Greeks

47

Flaws with Black Scholes & Exotic Greeks

48

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...SMALL THINGS LOOM LARGE: The Law of Small Numbers 62 HANDLE WITH CARE: Expectations 63 SPEED TRAPS AHEAD!: Simple Logic 64 HOW TO EXPOSE A CHARLATAN: Forer Effect 65 VOLUNTEER WORK IS FOR THE BIRDS: Volunteer’s Folly 66 WHY YOU ARE A SLAVE TO YOUR EMOTIONS: Affect Heuristic 67 BE YOUR OWN HERETIC: Introspection Illusion 68 WHY YOU SHOULD SET FIRE TO YOUR SHIPS: Inability to Close Doors 69 DISREGARD THE BRAND NEW: Neomania 70 WHY PROPAGANDA WORKS: Sleeper Effect 71 WHY IT’S NEVER JUST A TWO-HORSE RACE: Alternative Blindness 72 WHY WE TAKE AIM AT YOUNG GUNS: Social Comparison Bias 73 WHY FIRST IMPRESSIONS DECEIVE: Primacy and Recency Effects 74 WHY YOU CAN’T BEAT HOME-MADE: Not-Invented-Here Syndrome 75 HOW TO PROFIT FROM THE IMPLAUSIBLE: The Black Swan 76 KNOWLEDGE IS NON-TRANSFERABLE: Domain Dependence 77 THE MYTH OF LIKE-MINDEDNESS: False-Consensus Effect 78 YOU WERE RIGHT ALL ALONG: Falsification of History 79 WHY YOU IDENTIFY WITH YOUR FOOTBALL TEAM: In-Group Out-Group Bias 80 THE DIFFERENCE BETWEEN RISK AND UNCERTAINTY: Ambiguity Aversion 81 WHY YOU GO WITH THE STATUS QUO: Default Effect 82 WHY ‘LAST CHANCES’ MAKE US PANIC: Fear of Regret 83 HOW EYE-CATCHING DETAILS RENDER US BLIND: Salience Effect 84 WHY MONEY IS NOT NAKED: House-Money Effect 85 WHY NEW YEAR’S RESOLUTIONS DON’T WORK: Procrastination 86 BUILD YOUR OWN CASTLE: Envy 87 WHY YOU PREFER NOVELS TO STATISTICS: Personification 88 YOU HAVE NO IDEA WHAT YOU ARE OVERLOOKING: Illusion of Attention 89 HOT AIR:......

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...Growth Stock Valuing Nonconstant Growth Stocks 281 Stock Valuation by the Free Cash Flow Approach Market Multiple Analysis Preferred Stock 279 285 285 286 Stock Market Equilibrium 287 The Efficient Markets Hypothesis 290 Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293 Summary 294 Web Extensions 7A: Derivation of Valuation Equations CHAPTER 8 Financial Options and Applications in Corporate Finance Box: The Intrinsic Value of Stock Options Overview of Financial Options 305 306 306 Box: Financial Reporting for Employee Stock Options 309 The Single-Period Binomial Option Pricing Approach 310 The Single-Period Binomial Option Pricing Formula The Multi-Period Binomial Option Pricing Model The Black-Scholes Option Pricing Model (OPM) Box: Taxes and Stock Options The Valuation of Put Options 314 316 319 324 325 Applications of Option Pricing in Corporate Finance Summary 326 328 PART 4 Projects and Their Valuation 333 CHAPTER 9 The Cost of Capital 335 Box: Corporate Valuation and the Cost of Capital The Weighted Average Cost of Capital Basic Definitions 336 337 338 Cost of Debt, rd(1 − T) 340 Cost of Preferred Stock, rps 342 Box: GE and Warren Buffett: The Cost of Preferred Stock Cost of Common Stock, rs The CAPM Approach 343 344 345 Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach Over-Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach 353 355 Comparison of the CAPM, DCF, and......

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...(NPV) as the underlying and unifying concept in corporate ﬁnance. Many texts stop well short of consistently integrating this basic principle. The simple, intuitive, and very powerful notion that NPV represents the excess of market value over cost often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is ﬁrmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects. Also, students shouldn’t lose sight of the fact that ﬁnancial management is about management. We emphasize the role of the ﬁnancial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to decisions, and where appropriate, the approximate, pragmatic nature of ﬁnancial analysis is made explicit, possible pitfalls are described, and limitations are discussed. OUR APPROACH To achieve our objective of reaching out to the many different types of students and the varying course environments, we worked to distill the subject of corporate ﬁnance down to its core, while maintaining a decidedly modern approach. We have always maintained that corporate ﬁnance can be viewed as the working of a few very powerful intuitions. We also know that understanding the “why” is just as important, if not more so, than understanding the “how.” Throughout the development of this book, we continued to take a hard look at......

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...traders have different information—the opinions of an expert on weather and those of an expert on grocery marketing trends will both influence the market’s determination of the price of wheat. Our next job is to understand the roles prices play in conveying information that influences decisions of producers and consumers. Adam Smith In Chapter 2, self-interested individuals reached patterns of productive specialization and arranged trades that were economically efficient. Trading, however 54 Joel Hasbrouck, “One Security, Many Markets: Determining the Contributions to Price Discovery,” Journal of Finance 50 (September 1995): 1175–99; and Ananth Madhavan and Venkatesh Panchapagesan, “Price Discovery in Auction Markets: A Look Inside the Black Box,” Review of Financial Studies 13 (Autumn 2000): 627–58. Chapter 3: Markets 97 did not take place in markets. Instead, we saw only extremely simple transactions involving two people and two goods. In real life, however, production requires many individuals and coordinated use of the many different resources they bring with them. When there are millions of people who can produce thousands of different goods and services, the problem of efficiently assigning persons to activities is beyond the reach of computing power. The costs of solving it incorrectly can be very high. Yet the world attacks this problem every day with some success (if not theoretical perfection). The market prices of goods and resources adjust with......

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...models referred to in the Dictionary are named under communication models. ADVERTISING/MARKETING Advertising; Advertising Standards Authority (ASA); Attention model of mass communication; Audience: active audience; Audience: fragmentation of; Audience differentiation; Audience measurement; Brand; Campaign; Cognitive Consistency theories; Consumerization; Consumer sovereignty; Consumption behaviour; Content analysis; Culture: consumer culture; Custom audience research; Demographic analysis; Eﬀects of the mass media; Epistle; Ethnographic (approach to audience measurement); Focus groups; Gantt chart; Glocalization; Hidden needs; Hot buttons; Identiﬁcation; Idents; Image; Image: rhetoric of; Infomercials; JICNARS scale; Johnson and Scholes: stakeholder mapping; Marketing; Market research; Maslow’s hierarchy of needs; Motivation; Motixiv Topic guide vation research (MR); News: public relations news (PR); Niche audience; Nielsen ratings; Opinion leader; PIE chart; Psychological Reactance theory; Product placement; Public Aﬀairs; Public Relations (PR); Reception studies; Sampling; Sponsorship; Sponsorship of broadcast programmes (UK); Stakeholders; Subliminal; Role model; Tactics and strategies; Ten commandments for media consumers; Uses and Gratiﬁcations theory; VALS typology. AUDIENCES: CONSUMPTION & RECEPTION OF MEDIA Accessed voices; Attention model of mass communication; Audience; Audience: active audience; Audience: fragmentation of; Audience......

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...PART V FOREIGN CURRENCY DERIVATIVES 671 CHAPTER 20 Foreign Currency Futures and Options 20.1 The Basics of Futures Contracts 671 Futures Versus Forwards 671 The Pricing of Futures Contracts 675 20.2 Hedging Transaction Risk with Futures Hedging at Nancy Foods 678 Potential Problems with a Futures Hedge xx Contents 678 679 671 634 20.3 Basics of Foreign Currency Option Contracts Basic Option Terminology Options Trading 685 683 683 20.4 The Use of Options in Risk Management 689 A Bidding Situation at Bagwell Construction 689 Using Options to Hedge Transaction Risk 690 Hedging with Options as Buying Insurance 695 Speculating with Options 699 Options Valuation 701 20.5 Combinations of Options and Exotic Options Range Forwards and Cylinder Options Other Exotic Options 708 706 707 20.6 Summary 711 Questions 711 Problems 712 Bibliography 713 Appendix: Foreign Currency Option Pricing (Advanced) CHAPTER 21 Interest Rate and Foreign Currency Swaps 21.1 Introduction to Swaps 723 Parallel Loans and Back-to-Back Loans 724 Basic Aspects of Currency Swaps and Interest Rate Swaps The Size of the Swap Markets 726 Credit Default Swaps and the Financial Crisis 727 21.2 Interest Rate Swaps 714 723 725 728 Why Use Interest Rate Swaps? 728 The Nature of Interest Rate Swap Contracts Dealing with Credit Risks 732 21.3 Foreign Currency Swaps 730 732 The Mechanics of Modern Currency Swaps 734 Comparative Borrowing Advantages in Matched Currency Swaps 735 Swapping Bond......

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...PART V FOREIGN CURRENCY DERIVATIVES 671 CHAPTER 20 Foreign Currency Futures and Options 20.1 The Basics of Futures Contracts 671 Futures Versus Forwards 671 The Pricing of Futures Contracts 675 20.2 Hedging Transaction Risk with Futures Hedging at Nancy Foods 678 Potential Problems with a Futures Hedge xx Contents 678 679 671 634 20.3 Basics of Foreign Currency Option Contracts Basic Option Terminology Options Trading 685 683 683 20.4 The Use of Options in Risk Management 689 A Bidding Situation at Bagwell Construction 689 Using Options to Hedge Transaction Risk 690 Hedging with Options as Buying Insurance 695 Speculating with Options 699 Options Valuation 701 20.5 Combinations of Options and Exotic Options Range Forwards and Cylinder Options Other Exotic Options 708 706 707 20.6 Summary 711 Questions 711 Problems 712 Bibliography 713 Appendix: Foreign Currency Option Pricing (Advanced) CHAPTER 21 Interest Rate and Foreign Currency Swaps 21.1 Introduction to Swaps 723 Parallel Loans and Back-to-Back Loans 724 Basic Aspects of Currency Swaps and Interest Rate Swaps The Size of the Swap Markets 726 Credit Default Swaps and the Financial Crisis 727 21.2 Interest Rate Swaps 714 723 725 728 Why Use Interest Rate Swaps? 728 The Nature of Interest Rate Swap Contracts Dealing with Credit Risks 732 21.3 Foreign Currency Swaps 730 732 The Mechanics of Modern Currency Swaps 734 Comparative Borrowing Advantages in Matched Currency Swaps 735 Swapping Bond......

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