1

BASICS OF DERIVATIVES
PROF. NAVEEN BHATIA
2
Session 1
An Introduction to Derivatives,
Forwards & Futures
3
Introduction
A derivative is any instrument
which DERIVES its value
from an underlying security
Futures
Options
Forwards
Swaps
Underlying security may be a commodity, a stock, a stock
index, an exchange rate, a bond etc.
4
Applications of Derivatives
Derivatives are tools for transferring risk. They can be used to reduce
risk as well increase risk. For instance, hedgers use derivatives for
mitigation of risk, while speculators may be guided by the motive of
higher returns through extremely risky derivative exposures.

One of the reasons why derivatives have become popular is because
they allow risk to be traded efficiently.

Derivatives can provide leverage to the investors, magnifying both the
return on the upside to the investor and losses on the downside.

Derivatives dont reduce risk but redistribute risks from an overall
societys point of view. Derivatives often increase volatility; this may
be due to illiquid markets; other imperfections and herd behaviour.
5
Forward Contracts
A forward contract is an OTC agreement to buy or sell an asset at a
certain time in the future for a certain price.

In a forward contract, both the buyers and sellers are obligated to
honour the terms of the contract.

Forward contracts are not guaranteed formally by any exchange or
Clearing Corporation, hence counterparty risk is involved.

There is no daily settlement in case of forward contracts. At the end of
the life of the contract, one party buys the asset for the agreed price
from the other party.

6
Pricing a forward contract
F = S*(1 + RT)
F = Spot + Carrying cost

Pricing a forward contract (with intermittent cash flows)
F = {S PV(D)}e
RT
or F = {S PV(D)}(1 + RT)
F = Spot + Carrying cost Dividend

Forward rate for a security with no income
F = S*exp(RT)

Also,
F = S PV(K)
Valuing forward contracts
7
Pricing a Forward Contract
(Cash and Carry Model)

At time t = 0 (at initiation)








At time t = T (on expiry of the forward contract)
Forward
buyer
Dealer Financer
Spot asset
purchase
Borrows to
finance asset
Forward
Contract
Dealer Financer Forward
buyer
Repays
S(1 + RT)
For price k
Asset
8
Risk Neutral Valuation (No Arbitrage Argument)
A short position in forward/future is risky in case the asset goes up.

Can this risk be hedged?

Yes ! By going long in cash today.

The portfolio consisting of long cash and short future is risk free.

Therefore, Forward price = S*(1 + RT)

In other words, your investment in S must grow at a risk free rate.

If the underlying pays dividend, then the carrying cost is reduced by
the amount of dividend.
9
ARBITRAGE:
FUTURE AT A DISCOUNT
LETS SAY DISCOUNT OF 1.5%(K<S0)
A PERSON OWNING THE STOCK CAN SELL SPOT AND INVEST CASH IN
RFR. SIMULATANEOUSLY CAN GO LONG IN THE FUTURE.
WHEN THE DISCOUNT DISAPPEARS OR ON EXPIRT WHEN ST= FT, HE
CAN GO LONG ON THE STOCK AT ST. HIS PAYOFF WILL BE AS UNDER
PROFIT /LOSS FROM FUTURE = ST-K (CASH SETTLED)
CASH OUTFLOW FROM BUYING THE STOCK = -ST
INITIAL CASH INFLOW= S0
INITIAL CASH FLOW AT EXPIRY= S0(1+RT)
NET POSITION = ST-K-ST+S0(1+RT)= S0(1+RT)-K= 2-2.5%
IF 2-2.5% > TRADING COSTS,ARBITRAGE GOOD ENOUGH.

CARE : SETTLEMENT PRICE WEIGHTED AVERAGE OF LAST HALF AN
HOUR . SO LONG POSITION ON EXPIRY MUST BE BUILD ACCORDINGLY.

10
ARBITRAGE:
FUTURE CALENDER SPREAD
LETS SAY A STOCK LIKE RELIANCE
S0= 1400 F1= 1390 AND F2= 1410
SHORT CALENDER SPREAD BUY F1 AT 1390 AND SELL F2
AT 1410.
BASICALLY YOU HAVE SOLD A SPREAD AT 20 POINTS
YOU WOULD LIKE TO REVERSE YOUR POSITION WHEN
THE APREAD NARROWS OR BECOME NEGATIVE.
LETS SAY ON EXPIRY OF FIRST MONTH YOU SQUARE
OFF
PAY OFF FROM LONG F1= ST- 1390
PAYOFF FROM SHORT F2= 1410-(ST-?) ? ASSUMES THE
NEXT MONTH FUTURE IS AT DISCOUNT
NET GAIN IS 20+?
11
ARBITRAGE:
INDEX ARBITRAGE:
SUPPOSING, NIFTY FUTURE DISCOUNT > STOCKS THAT
COMPRISE NIFTY.
BUY NIFTY FUTURE AND SHORT STOCK FUTURE IN
WEIGHTS AS IN NIFTY.
WHEN THE DISCREPENCE DISAPPEARS, REVERSE THE
TRADE.
ON EXPIRY BOTH WILL BE EQUAL , SO THE TRADE WILL
BE PROFITABLE.
12
Hedging using Forward Contracts
Suppose today is Jan 25, 2009 and an Indian company has pay
$10 million for imports from USA on April 25, 2009 months and
decides to hedge using a long position in a forward contract.

The Indian company could hedge its foreign exchange risk by
buying dollars from a financial institution in the 3 months forward
market at Rs. 45/US$. Thus it fixes the price to be paid to the US
exporter at Rs. 450 million.

If the exchange rate on April 25, 2009 is Rs. 42/US$, the company
incurs a notional loss of Rs. 30 million which it could have avoided
had it not hedged its risk in the forward market and bought dollars
in the spot market instead.

If the exchange rate is Rs. 48/US$, the companys hedge has paid
off as it has reduced its cost by Rs. 30 million.
13
Futures Contracts
A future contract is a type of forward contract with highly standardised
and closely specified terms. They are standardised in terms of maturity
periods (particular month and day), contract size, settlement price (the
way it is calculated), minimum price fluctuation (tick size) and daily
price limits (which restricts the price movement in a single day).

Futures contracts are exchange driven. The performance of a future
contract is guaranteed by a clearing house which is associated with
the exchange.

The clearing house and the exchange are able to guarantee all future
contracts by a special margining system. All the traders are required
to deposit an initial margin with the broker, which is to ensure that
traders will perform on their contract obligations.
14
Another safeguard that is built in the futures trading system is daily
settlement or marking to market. In the futures market, traders are
required to realise any losses in cash on the day they occur. Any
gains in the future position is credited to long position and the same
amount is debited to sellers account. On the debit side, the moment
the total margin falls below the maintenance margin (which is usually
75% of initial margin), the margin level must be brought back to the
initial margin level by paying in cash the variation margin.


Delivery and Settlement of a futures contract: Most futures contracts
are closed out before maturity. In practice, very few future contracts
are closed through either physical delivery or cash settlement. Most of
the traders close their position through an offsetting trade. For
instance, a trader who is long in Nifty futures (expiring on last
Thursday of a month) would sell equal no. of futures before the expiry
and bring his net position back to zero.

Futures Contracts
15
Long Forward /
Future
Payoff
Price of Underlying
at Maturity
Payoff
Price of Underlying
at Maturity
Short Forward /
Future
16
Forward vs Futures Contracts
Private contract between 2 parties Exchange traded
Not
standardized
Standard contract
Usually 1 specified delivery
date
Range of delivery dates
Settled at maturity Settled
daily
Delivery or final cash
settlement usually occurs
Contract usually closed out
prior to maturity
FORWARDS FUTURES
Some credit risk Virtually no credit risk
17
Valuing a foreign currency forward/future
F = S x (1 + iH x T) S x {1+ (iH iF) x T} (Carrying cost = Interest rate Differential)
(1 + iF x T)
Rs. 48
Invest or borrow
Invest or borrow
at domestic interest rates
(5%)
at foreign interest
rates (1%)
1 $
Rs. 50.04
F = 48 x 1.05
$ 1.01
1.01
S = 48
= 49.90
18
Valuing a commodity forward/future
Forward price = Spot {1 + [(R + S) C] x T}

Here,
R =I nterest rate
S =Storage cost
C =Convenience yield
T =Time to maturity

19
Contango vs Backwardation
Based on the relationship between spot and forward prices, the
forward price of a commodity is greater than the spot price as the
carrying costs are positive.

Markets in which forward rate is greater than spot rate are known as
contango.

When the forward price is less than the spot price or distant forward
price is less than near forward price (implying negative total carrying
costs), the markets are said to be in backwardation. This is
commonly observed in a number of commodities such as crude oil
and certain agricultural products.

Backwardation normally occurs due to shortage of supply of a
commodity for immediate delivery. This may happen due to a sudden
surge in demand vis--vis supply and usually in commodities, it takes
some time before new capacity can be added to match the increased
demand. The backwardation in the forward market may reflect this lag.
20
Convenience Yield
The concept of convenience yield is equivalent to a net earning or
yield accruing to the owner of a physical commodity.

In a simple sense, this can be equated to the return that can be earned
by a commodity owner by lending out the commodity asset.

Convenience yield can be estimated by analysis of historical data. It
can also be derived from the observed spot and forward prices.

Research has shown that convenience yield is inversely related to the
level of inventories. In addition, there is evidence of mean reversion in
convenience yields.

Further there is evidence of significant differences in the levels of
convenience yields between commodities.

Commodities prices are often in backwardation because C > R + S.
21
Convergence of Futures to Spot
(when Carrying Cost = 0)

Time Time
(a) (b)
Futures
Price
Futures
Price
Spot Price
Spot Price
22
Hedging using Index Futures
Index
Nifty 2800
Min. contract (MC) 50
Cash index (I) 140000
Portfolio
Size (P) 560000000
Beta () 1.5
No. of contracts 6000
Hedge
Future 3 months
Rfr 10%
Rfr for 2 m and 3m resp. 1.67% and 2.5%
Future value
F = 2800 x [1 + (10% x 3/12)]
2870
Contract (F x MC) 143500
23
Index value
(3m)
2240 2380 2520 2660 2800 2940 3080 3220 3360
Profit/Loss on future
R
m

-20% -15% -10% -5% 0% 5% 10% 15% 20%
Future value
on exp
2240 2380 2520 2660 2800 2940 3080 3220 3360
Future sold at 2870 2870 2870 2870 2870 2870 2870 2870 2870
Profit on
future
630 490 350 210 70 -70 -210 -350 -490
Profit/Future
contract
31500 24500 17500 10500 3500 -3500 -10500 -17500 -24500
Total
Profit/Loss
(Rs. in mn.)
189 147 105 63 21 -21 -63 -105 -147
Rm =[Index value (3m) Nifty]/Nifty, Future value (2m) =[Index value (3m)(1 +10%/12)] ,
Total Profit/Loss =Profit/Future contract x Contract
Hedging using Index Futures
24
* (P/L on portfolio =R
P
x P)
Profit/Loss on cash (portfolio)
R
P
(in %) =
Rfr + (R
m

Rfr)
-31.25 -23.75 -16.25 -8.75 -1.25 6.25 13.75 21.25 28.75
P/L on
Portfolio
(Rs. in mn)
-175 -133 -91 -49 -7 35 77 119 161
Total Portfolio value on exp. of future = Original Portfolio + P/L on futures + P/L on portfolio
Total Port.
Value
(Rs. in mn)
574 574 574 574 574 574 574 574 574
Portfolio x
(1 + Rfr)
(Rs. in mn)
574 574 574 574 574 574 574 574 574
Hedging using Index Futures
25
Speculation using Futures
Say a speculator wants to bet on a hunch that the British pound will
strengthen over the US dollar in the next 2 months and is willing to risk
250,000 towards his bet.

He has 2 options. He can purchase 250,000 outright in the spot market
and sell it at a later date at a higher price. Alternatively, he can take a
long position in 4 April futures contracts on sterling. (Each futures
contract is for the purchase of 62,500). The table below summarises the
payoffs for both the trades. (Spot price = 2.0470$/ and April futures
price = 2.0410$/)
Buy 250,000 Buy 4 futures
contracts
Profit if April spot = 2.1 $13,250 $14,750
Loss if April spot =2.0 -$11,750 -$10,250
26
Session 2
Options & Option Greeks
27
Option Basics and Terminology
While a forward contract implies an obligation to buy or sell the asset,
an option contract gives the buyer the right but no obligation to buy or
sell the asset at a predetermined price during a set period of time.

A call option gives the purchaser the right to purchase an asset and a
put option gives the purchaser the right to sell the asset.

Features of option contracts:
Exercise price/Strike price : The price at which the buyer of an option
has the right to buy or sell the asset.

Exercise or expiry date : The option can be exercised by the buyer any
time upto the expiration date in case of American options and on a
single date i.e. expiration date in case of European options.

Option premium/price : The buyer of the option pays an upfront
premium to the seller of the option. The premium is paid by the buyer for
receiving the right to buy or sell the asset at the strike price on or by the
exercise date.
28
Moneyness
At any time, an option may be in-the-money, at-the-money or out-of-the
money. A call option is said to be in-the-money if the price of the
stock (which we shall assume is the underlying asset) is greater than
the exercise price, while if the stock price is lower than the exercise
price, the call is said to be out-of-the-money.

For put options, the reverse holds, so that if the exercise price of a put
is greater than the stock price, then the put is said to be in-the-money
and out-of-the-money if the former is lower than the latter.

In each case, however, the option is said to be at-the-money if the
stock price equals the exercise price.
At-the-money In-the-money
Out-of-the-
money
Calls S
T
= K S
T
> K S
T
< K
Puts S
T
= K S
T
< K S
T
> K
29
Options total value
The premium or the price of an option is made up of two components,
namely,

1. Intrinsic value: Intrinsic value refers to the amount by which an
option is in-the-money. An option which is out-of-the-money or at-
the money has zero intrinsic value.




Intrinsic value of a call option = max(0, S
T
K)
Intrinsic value of a put option = max(0, K S
T
)
30
2. Time value: Time value of an option is the difference between the
premium of the option and the intrinsic value of the option. For a
call or put option, which is at-the-money or out-of-the-money, the
entire premium amount is the time value. Generally, other things
being equal, the longer the time to maturity, the greater shall the
time value be.






In case of a call which is in-the-money, time value exists if the call
price, C, is greater than the intrinsic value, S
T
K.

Similarly, an in-the-money put option has time value if its premium
exceeds the intrinsic value, K S
T
.
Intrinsic value of a call option = C {max(0, S
T
K)}
Intrinsic value of a put option = P {max(0, K S
T
)}
Options total value
31
Behaviour of Time value
Change in Time value with respect to stock price:
Time value is maximum for ATM options.
As we go INM / OTM, time value declines quite symmetrically.


Change in Time value with respect to time to maturity:
Time value declines as an option approaches expiration but the
decline is not linear.
The decline in time value increases exponentially as an option
approaches maturity.

32
S
0
2800 2800 2800 2800 2800 2800 2800 2800 2800
X 2600 2650 2700 2750 2800 2850 2900 2950 3000
r 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10
0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30
T 0.08 0.08 0.08 0.08 0.08 0.08 0.08 0.08 0.08
lns/k 0.07 0.06 0.04 0.02 0.00 -0.02 -0.04 -0.05 -0.07
0.5
2
0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
T 0.09 0.09 0.09 0.09 0.09 0.09 0.09 0.09 0.09
d1 1.00 0.78 0.56 0.35 0.14 -0.06 -0.27 -0.46 -0.66
N(d1) 0.84 0.78 0.71 0.64 0.56 0.47 0.40 0.32 0.26
d2 0.91 0.69 0.47 0.26 0.05 -0.15 -0.35 -0.55 -0.74
N(d2) 0.82 0.75 0.68 0.60 0.52 0.44 0.36 0.29 0.23
An Illustration
(Impact On Time value as option moves INM / OTM)
33
Call 242.79 203.76 168.12 136.24 108.37 84.56 64.69 48.52 35.67
Int val 200 150 100 50 0 0 0 0 0
TV 42.79 53.76 68.12 86.24 108.37 84.56 64.69 48.52 35.67
INM ATM OTM
Put 21.21 31.77 45.71 63.42 85.13 110.90 140.62 174.04 210.77
Int val 0 0 0 0 0 50 100 150 200
TV 21.21 31.77 45.71 63.42 85.13 60.90 40.62 24.04 10.77
OTM ATM INM
Xexp(-rt) 2578.42 2628.01 2677.59 2727.18 2776.76 2826.35 2875.93 2925.52 2975.10
C 242.79 203.76 168.12 136.24 108.37 84.56 64.69 48.52 35.67
S-Xexp(-rt) 221.58 171.99 122.41 72.82 23.24 -26.35 -75.93 -125.52 -175.10
P 21.21 31.77 45.71 63.42 85.13 110.90 140.62 174.04 210.77
Illustration (Contd.)
34
Boundary conditions for options
First Boundary condition:
C
A
or C
E
0
P
A
or P
E
0

The price of any option is always 0. Option exercise is voluntary and
therefore buyers will not exercise if exercising results in a loss. Option
prices cant be negative.


Boundary condition at maturity:
C
A
or C
E
= max(0, S
T
K)
P
A
or P
E
= max(0, K S
T
)

35
Boundary condition prior to maturity (American options)
C
A
0 and S
T
K
P
A
0 and K S
T

C
A
max(0, S
T
K)
P
A
max(0, K S
T
)

Since American options can be exercised prior to maturity, the
options value must be options intrinsic value.

Relationship between European and American options
C
A
C
E
P
A
P
E

This must be true since American options have all the features of
European options and in addition give the holder the flexibility of early
exercise.
36
Lower Bound for European Call Option Prices; No Dividends
C
E
S
0
PV(K)

Lower Bound for European Put Prices; No Dividends
P
E
PV(K) S

Upper Boundary limit for American and European options
C
A
or C
E
S
P
A
or P
E
K

Impact of Dividends on Lower Bounds to Option Prices
C S
0
D PV(K)
P D + PV(K) S
0


37
(a) Long Call
(b) Short Call
(c) Long Put
(d) Short Put
38
Factors affecting option values
Current Price of the underlying asset (S)
Exercise Price of the option (K)
Interest Rates (R
f
)
Time to Expiry (T)
Volatility of prices of the underlying asset (o)
B & S Model takes these 5 variables as inputs
The only variable traders often agree upon is volatility.
39
The table below illustrates the effect of an increase in
each pricing factor on the option value, holding other
factors constant.
Pricing factor Call option Put option
Current Asset price (S) Increase Decrease
Strike price (K) Decrease Increase
Volatility (o) Increase Increase
Time to expiration (T) Increase Increase
Interest rate (R
f
) Increase Decrease
Factors affecting option values
40
Put-Call Parity; No Dividends
Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of the
strike price in cash
Portfolio C: European put on the stock + the stock
Both are worth MAX(S
T
, K ) at the maturity of the options
They must therefore be worth the same today
This means that
C P = S PV(K)
41
Interpretations of Put Call Parity
A long position in a European call at a strike price k and a short
position in a European put at strike price k is equivalent to a long
forward position at k.



=
Short Put
- P
Long Forward
F
Long Call
C
42
A deeply in-the-money call behaves like a long forward because:
C P = F
C = F + P
C = F + P
When a call is deeply in-the-money, P = 0; Delta of put = 0
Therefore; C = F = 1

Similarly a deeply in-the-money put behaves like a short forward.

Expected returns from the underlying dont matter in the valuation of
options.

When volatility increases, prices of both calls and puts also increases,
but the put call parity will be maintained.
Interpretations of Put Call Parity
43
If the strike price k is equal to the theoretical forward price
[i.e. S
0
(1 + RT)], then,
C
E
P
E
= S
0
PV[S
0
(1 + RT)] = 0
C
E
= P
E

Therefore, C
E
= P
E
when k = theoretical forward price.

If k < theoretical or equilibrium forward price, then C
E
P
E
is positive
or C
E
> P
E
. In other words, if we create a synthetic forward position at a
price less than the equilibrium forward price, then it would cost us an
amount S
T
PV(k). This, is nothing but the value of a forward contract.

If k > theoretical or equilibrium price, C
E
P
E
is negative or European
puts will be less expensive than American puts.
Interpretations of Put Call Parity
44
Violation of Put Call Parity
If the put call parity does not hold there are arbitrage opportunities.
Lets understand this through an example.

S = 100, K = 100, Interest rate = 1%, C = 4, P = 3

If market price of call = 5, then we can exploit the arbitrage opportunity
by selling the call at 5 and simultaneously creating a synthetic long
call position; +P + S PV(K)

Here, -PV(K) which is nothing but the borrowed amount of 98 (-100 3
+ 5) which when invested @ 1% inflates our total liability to 98.98

The following table gives you the expected payoff of the portfolio on
maturity:

45
I f S
T
> 100

I f S
T
< 100
Call exercised: Sell stock
for 100
Exercise put to sell stock
for 100
Pay 98.98 Pay 98.98
Net profit = 100 98.98 =
1.02
Net profit = 100 98.98 =
1.02
* Thus our arbitrage profit in either of the scenarios will be 1.02
Violation of Put Call Parity
46
Long dated options (LEAPS)
Meaning: LEAPS is an acronym for Long-term Equity Anticipation
Securities. These are equity and index options that are issued with
original maturities of 2 to 3 years.

Benefits of LEAPS:
Stock Alternative: LEAPS offer investors an alternative to stock
ownership. LEAPS calls enable investors to benefit from stock price
rises while placing less capital at risk than is required to purchase
stock.

Diversification: Investors also use LEAPS calls to diversify their
portfolios. A buyer of a LEAPS call has the right to purchase shares of
stock at a specified date and price up to three years in the future.
Thus, an investor who makes decisions for the long term can benefit
from buying LEAPS calls.
47
Hedge: LEAPS puts provide investors with a means to hedge current
stock holdings. Investors should consider purchasing LEAPS puts if
they are concerned with potential price drops on stock that they own.

Issues concerning LEAPS:
LEAPS Pricing: Pricing longer-term options is more difficult than
pricing shorter-term options. With shorter-term options, it is fairly
straightforward to use an interest rate which approximates the "risk-
free" interest rate. Interest rates play a more significant role in the
pricing of longer-dated options, due to the length of time involved.

Effect of Greeks: The time erosion that occurs in the first several
months of a LEAPS option is minimal. However, when LEAPS options
become shorter-term options (time to expiration is less than one year),
they behave like all other shorter-term options. Buyers of LEAPS
options have less time premium erosion to fight than buyers of
shorter-dated options. The tradeoff, however, is that LEAPS options
offer less leverage. The deltas of LEAPS options will not increase
dramatically as with shorter-dated options since there is so much time
remaining until expiration. Any increase in option value due to an
increase in the price of the underlying stock will be tempered by this
lower gamma effect.
Long dated options (LEAPS)
48
Delta

Delta may be defined as the change in the option price per unit change
in the price of the underlying. It may also be understood that as the
price of the underlying changes, the delta of an option also changes.

Delta of a call is always less than 100. A delta of 1 may be written as
100. Delta for a call varies from 0 to 100 as we go from OTM call to ITM
call and delta for a put varies from 0 to -100 as we go from OTM put to
ITM put. Call options which are at the money have deltas close to 50.

From put call parity, we know that C P = F and therefore, it follows
that delta of put = 1 delta of call.

Delta is 50 around the forward price (not the spot price). In other
words, when exercise price = forward price, delta is close to 50.

Delta hedging:
Long units of underlying + Short 1 call = market neutral.
Option Greeks
49

Gamma

The rate of change of delta with that of the underlying is known as
gamma. Gamma tells us how much delta should change per unit of
infinitesimally small change in the price of the underlying stock
holding other variables constant.

Delta is not constant and changes from 0 to 100 for calls as the
underlying price moves up and from -100 to 0 for puts as the
underlying price moves up.

Please remember for any long option position whether calls or puts,
gamma is always positive.

The frequency with which delta hedging needs to be done is a
function of level of gamma risk. A trader is often required to make a
trade-off between frequency of hedging and trading costs.

Rho

The rho of a portfolio measures the rate of change of the value of
portfolio with respect to the interest rate.
50
Theta

Theta of an option is defined as change in the value of portfolio of
options with the passage of time. It is also referred to as the time
decay of the portfolio.

A long option position will always have a negative theta and a short
option position; a positive theta.

A gamma and theta position will be opposite in sign and size will also
correlate.

As expiration approaches gamma of an ATM option becomes
increasingly large and the same is also true about theta.

Every option position is a trade-off between market movement and
time decay.
51
Vega

The vega of a portfolio measures the rate of change of the value of the
portfolio with respect to changes in the volatility of the underlying
asset.

Black and Scholes model is actually inconsistent with changing
volatility. The model assumes that volatility will remain constant for the
full life of the option.

Vega increases with the increase in time to maturity.

ATM options are most sensitive to total points change to a change in
volatility. An OTM option is most sensitive in % terms to change in
volatility.

Vega of an ATM is constant at various volatility levels and vega of an
ITM or OTM option increases with the increase in volatility.
52
Session 3
Option Trading Strategies
53
Covered Call
A covered call strategy involves going long on a stock and short on a
call. Covered option writing protects from the downside upto the
amount of the premium, and caps your upside potential.

This strategy can generate income for the investor in an otherwise
static environment. By selling a call an investor receives option
premium to bolster an otherwise small or negative return.

Risk is asset price may go higher
than premium that you receive.

Risk reduction strategy? How?

Profit
S
T
54
Protective Put
An investor with a long-term bullish view on the stock may not be
willing to do away with the upside potential, but at the same time
wants to be insured against the probability of downside. A protective
put strategy which involves going long on a stock and long on a put,
provides insurance against stock declines for such investors.

When you buy a put as a protection, the time value of the put is always
a loss whether the stock goes up or down. In that sense it is like an
insurance policy.

Issues in Implementation:

When to square your position
(if correction happens before expiry)

Which strike price or combination
of strikes?
Profit
S
T
55
A payoff similar to protective put can be achieved by:

Selling your stock and buying call and investing the balance proceeds
in a risk-free asset.

Very often the above strategy is better.

The capital guarantee products do exactly the same thing.

The same payoff can also be achieved by futures by ensuring delta of
the portfolio with futures is same as delta of portfolio with put option.

This was done in the Portfolio Insurance Scheme.
Portfolio Insurance Scheme
56
Portfolio: 100 Stocks & 100 Puts
S
0
88 90 92 95 98 100 102 105 108 110
K 100 100 100 100 100 100 100 100 100 100
S 100 100 100 100 100 100 100 100 100 100
(1 Put) -1 -0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 0
(100 Puts) -100 -90 -80 -70 -60 -50 -40 -30 -20 0
Portfolio 0 10 20 30 40 50 60 70 80 100
When of portfolio =0, it implies that we are perfectly hedged.

When of portfolio =100, it implies that we are going in line with the
asset price.

The same net delta position can be achieved by selling relevant no. of
futures.
Illustration
57
Introduction to Spreads
A spread is a position that consists of being long one or more options
on a stock and short one or more options on the same stock of a
different series (different strike; expiration) etc.

A spread increases the price range over which money can be made
but it is done at the cost of limiting the upside potential.

Types of Spreads:
Vertical or Directional spreads consist of two options with the same
expiration but with different strike prices. Eg. Bull & Bear Spreads.

The horizontal spread or calendar spread consists of two options with
the same strike price but with different expirations.

The third kind of spreads are known as volatility spreads when the
buyer makes profit if the stock moves either way but by a large
amount. Eg. Straddles, Strangles.
58
Bull Spreads
A bull spread reflects the bullish sentiment of a trader. Bull
spreads have limited profit potential with limited risk.

Bull spreads can be created using both calls and puts. A bull call
spread is a debit spread consisting of going long on a call at a
lower strike price and shorting a call at a higher strike price with
the same expiry.

Similarly a bull put spread is created using puts. However, a bull
put spread is a credit spread. The goal is to see the underlying
asset move higher and for both puts to expire worthless. If so, the
strategist can keep the net credit, which is also the maximum
reward. Since a credit spread has a higher success rate than a
debit spread, the amount at risk will often be higher than the
possible reward.
59
Bull Call Spread Bull Put Spread
S
T
K
1
K
2
Profit
S
T
K
1
K
2
Profit
Max. risk Max. reward Breakeven
Bull Call
Net debit Diff. in strikes Net
debit
Lower strike price
+ Net debit
Bull Put
Diff. in strikes Net
credit
Net credit Higher strike price
Net credit
60
Bear Spreads
In a bear call spread, you sell the lower strike call and buy the
higher strike call with the same time to expiry. A bear call spread is
a credit spread. As long as the underlying closes at expiration
below the lower strike call, the entire net premium becomes a
profit.

In a bear put spread, you buy a higher strike price put and sell a
lower strike price put with the same expiry. The idea is to lower the
cost of buying a straight put by selling a lower strike put. Though
this limits the maximum profit, it also lessens the trades risk. If the
underlying moves higher, a bear put spread is going to see a much
smaller loss than a straight put. However, over time, a credit
spread trader should see substantially more wins than losses.

In case of bull and bear spreads, the choice of strike price (INM/
ATM/ OTM) is a function of delta (risk) of the spread you want and
your view of the market.

Remember that OTM calls provide higher leverage.
61
Bear Call Spread
Profit
K
1
K
2
S
T
Bear Put Spread
K
1
K
2
Profit
S
T
Max. risk Max. reward Breakeven
Bear Call
Diff. in strikes Net
credit
Net credit Lower strike price +
Net credit
Bear Put
Net debit Diff. in strikes Net
debit
Higher strike price
Net debit
62
Also referred to as Horizontal Spreads or Time Spreads, Calendar
spreads are created using options which have the same strike price
but different expiration dates.

A long calendar spread involves purchasing a longer term option and
selling the near-term option. The longer the maturity of the option, the
more expensive it usually is. A calendar spread therefore usually
requires an initial investment.

When a short-term option is purchased and the long-term is sold, you
have created a short calendar spread.

The value of a time spread depends not only on the movement in the
underlying market, but also on other traders expectations about
future market movements as reflected in the implied volatility.

A long time spread always wants the underlying market to sit still and
benefits from an increase in implied volatility.
Calendar Spreads
63
Rationale behind Calendar Spreads
Theta of an option falls at a lower rate initially and at a faster rate as the
option approaches maturity (provided S is stable). Lets consider the
following example.




If after 1 month, S remains the same;




Here the 1 month option will lose the entire time value of Rs. 4 if S is
stable whereas the 3 month option will lose time value of Rs. 2.
+ 3m - 1m Net
Time value - 7 + 4 - 3
2 m 0 m Net
Time value 5 0 5
64
Gain on 1m option 4
Loss on 3m option - 2
Net Gain 2
This implies ~





If S makes a huge move, then intrinsic values get cancelled out
and we lose Rs. 7 on 3m option and gain Rs. 4 on 1m option
and we are left with a net loss of Rs. 3.
Gain on 1m option 4
Loss on 3m option - 7
Net Loss - 3
Rationale behind Calendar Spreads
65
Calendar Spread
using Calls
Profit
S
T
K
Calendar Spread
using Puts
Profit
S
T K
66
A butterfly spread involves buying a call option with a relatively low
exercise price, K
1
, buying another call option with a relatively high
exercise price, K
3
, and selling 2 call options with a strike price, K
2
,
which is halfway between K
1
and K
3
.

At expiration, a butterfly will always have a value somewhere between
zero and the amount between exercise prices. It will be worth zero if
the underlying contract is below the lowest exercise price or above the
highest exercise price, and it will be worth its maximum if the
underlying contract is right at the inside exercise price.

An important characteristic of a butterfly is its limited risk. If a trader
initiates a long butterfly in the belief that the market is unlikely to
move very far from the current price, the most he can lose if he is
wrong is the amount he laid out to purchase the butterfly. On the other
hand, if a trader sells a straddle and the market makes a large move,
his potential risk is unlimited.
Butterfly Spreads
67
Butterfly Spread
using Calls
K
1
K
3
Profit
S
T
K
2
K
1
K
3
Profit
S
T
K
2
Butterfly Spread
using Puts
Long Butterfly: Net debit =Long Short premiums
Max. risk Max. reward Upside Breakeven Downside
Breakeven
Net debit Diff. in strikes Net
debit
Higher strike price
Net debit
Lowest strike price
+ Net debit
68
Straddle
A straddle involves buying a call and put with the same strike price
and expiration date. If the stock price is close to the strike price at
expiration of the options, the straddle leads to a loss. However, if there
is a sufficiently large move in either direction, a significant profit will
result.

A straddle is appropriate when an investor is expecting a large move
in a stock price but does not know in which direction the move will be.

A long straddle has limited risk and unlimited profit potential. The
traders profit is unlimited in either direction. If the market moves
sharply up or down, the straddle will realise ever increasing profits as
long as the market continues to move in the same direction. A long
straddle is used when IVs are low or reasonable and expected to rise.

A short straddle will realise its maximum profit if the market stays
close to the call and put exercise price. The spread has limited profit
potential, and unlimited risk should the market move violently in either
direction which makes it a very risky strategy. A short straddle is
suitable when IVs are high and markets are expected to be stable.
Short straddles are the riskiest of all strategies. If not delta hedged,
the profit potential is limited, while risk is unlimited for a short
straddle.
69
Long Straddle
Profit
S
T
K
Short Straddle
S
T
K

Profit
Max. risk Max. reward Upside
Breakeven
Downside
Breakeven
Long Straddle Net debit Unlimited ATM strike +
Net debit
ATM strike
Net debit
Short Straddle Unlimited Limited to net
credit
ATM strike +
Net credit
ATM strike
Net credit
70
Barings Bank
Leesons activities were free from supervision and control.

His trading activities were undetected as a consequence of failure of
management and the failure of internal controls.

Leeson was able to create a special bank account to hide losses.

In 1994, Leesons trading activity produced 28.5 mn pounds or 71% of
the Barings total profits.

Leeson was also in charge of the paper work to settle the trades.
Lesson used to get high bonuses on the profits.

Leeson took a bet on the Japanese markets to rise. He invested in
futures contracts. An investor in the futures contracts can take very
large bets with very little capital.

71
The Japanese markets fell by 13.5% in the first two months of 1995
due to Kobe earthquake.

Leeson used to sell straddles on Nikkei 225. He used to make money if
the level of Japanese markers remained in a narrow range.

Leeson sold large no. of straddles in 1994. After the earth quake, the
volatility increased and these options became more expensive.

Leeson began building long positions in the futures assuming that the
Japanese stock market had overreacted to the quake and also thinking
that buying these futures in a big way could drive the market up and
thereby offsetting his losses in the short-straddle position.

Leesons option trading strategy was volatility trading, attempting
to take advantage of mispricing. Options become more expensive
when markets are volatile. This is why he went short on straddles.
Barings Bank
72
Barings Bank
In case of written straddle on the Nikkei 225, a fall in index will cause
the writer of straddle to have an equivalent long position in the Nikkei
225, because if the market fell, the put will be exercised.

Most of the option writers would do dynamic hedging, buying or
selling in the cash market when the market is rising or falling.
Obviously lesson didnt try to hedge his positions.

To satisfy margin calls on the futures lesson sold further additional
options to collect premiums, thereby leveraging his position further.

The management is also to be blamed for the fact that the
management didnt have proper risk management systems in place.

73
Strangle
In a strangle, an investor buys a put and a call with the same expiration date but
diff. strike prices. The call strike price is higher than the put strike price.

A strangle is commonly assumed to consist of OTM options. A strangle is
usually considered the most highly leveraged of all option positions because
OTM options are cheap relative to other options.

A strangle is a similar strategy to a straddle. The investor is betting that there
will be a large price move, but is uncertain whether it will be an increase or a
decrease. The stock price has to move farther in a strangle than in a straddle
for the investor to make a profit. However, the downside risk if the stock price
ends up at a central value is less with a strangle.

The profit pattern obtained with a strangle depends on how close together the
strike prices are. The farther they are apart, the less the downside risk and the
farther the stock price has to move for a profit to be realised.

As with a short straddle, a short strangle is appropriate for an investor who
feels that large stock price moves are unlikely. It is a risky strategy involving
unlimited potential loss to the investor.
74
Long Strangle
K
1
K
2
Profit
S
T
K
1
K
2
Profit
S
T
Short Strangle
Max. risk Max. reward Upside
Breakeven
Downside
Breakeven
Long Strangle Net debit Unlimited Call strike +
Net debit
Put strike
Net debit
Short Strangle Unlimited Limited to net
credit
Call strike +
Net credit
Put strike
Net credit
75
Greeks in Option Strategies
Type of Strategy Delta Gamma Vega Theta
Bull
Spread
Bull Call
+
Not very
relevant
Bull Put
+
Bear
Spread
Bear Call
-
Bear Put
-
Straddle
Long Straddle
0 + + + + - -
Short Straddle
0 - - - - + +
Strangle
Long Strangle
0 + + + + - -
Short Strangle
0 - - - - + +
Butterfly
Spread
Long Butterfly
0
Slight -ve Slight -ve Slight +ve
Short Butterfly
0
Slight +ve Slight +ve Slight -ve
Calendar
Spread
Long Calendar
0
- + +
Short Calendar
0
+ - -
76
Session 4
Black & Scholes Model and
Options Volatility
77
Stochastic process:
When asset prices fluctuate through time according to laws of
probability.

Markov process:
Only current value of variable is relevant to predict the future value.
Probability distribution of price at any future time is not dependent on a
particular path followed by a price in past.

Weiner process:
Particular Markov process with mean 0 and variance of 1 per year
Brownian motion dz = sqrt(dt)
is a random variable with mean 0 and variance 1
dz is a random variable with mean 0 and variance dt

Generalised Weiner process:
When we apply Weiner process to stocks prices some important factors
or properties of stock prices come into picture.
Some Terms
78
a) Stock prices drift up in the long run. This essentially represents the
returns from bearing risk.

b) Stock prices can never become negative.

c) We cannot use the basic Weiner process for stocks, for different
stocks have different volatilities.

d) Stocks returns can be described by two properties: expected
returns and variance. This leads us to a Generalized Weiner process
for stock returns (not prices).

R = dt + * * sqrt(dt)

Note that a drift component has been added and random variable
has been multiplied by variance; or we can say that random variable
has a mean 0 and variance .

The process explained earlier is also known as Geometric Brownian
motion. It is geometric in the sense that proportional change or
percentage change follow stochastic process.

Some Terms
79
The Stock Price Assumption
Consider a stock whose price is S

In a short period of time of length ot, the return on
the stock is normally distributed:



where is expected return and o is volatility

( ) t t
S
S
o o o | ~
o
,
80
The Lognormal Property
It follows from this assumption that






Since the logarithm of S
T
is normal, S
T
is lognormally
distributed
ln ln ,
ln ln ,
S S T T
S S T T
T
T
~
|
\

|
.
|

(
~ +
|
\

|
.
|

(
0
2
0
2
2
2
|
o
o
|
o
o

or

The Lognormal Distribution
A variable such as a stock price which can take any value between 0 &
infinity is lognormally distributed.

If a stock price is described by a log-normal distribution than ln(S
T

+1/S
T
) which represent the continuous compounded returns follows a
normal distribution with mean = ( - ^2/2)T and variance T.

A lognormal distribution is skewed positively or toward upside
because upside prices resulting from a positive rate of return will be
greater than downward prices resulting from a negative rate of return
E S S e
S S e e
T
T
T
T T
( )
( ) ( )
=
=
0
0
2
2
2
1

var

o
82
Continuously Compounded Return, q
S S e
T
S
S
T
T
T
T
=
~
|
\

|
.
|
0
0
1
2

or
=
or

2
q
q
q |
o o
ln
,
83
The Expected Return
The expected value of the stock price is S
0
e
T
The expected return on the stock is
o
2
/2


| |
| | =
o =
) / ( ln
2 / ) / ln(
0
2
0
S S E
S S E
T
T
84
The Concepts Underlying Black-Scholes
The option price and the stock price depend on the
same underlying source of uncertainty

We can form a portfolio consisting of the stock and
the option which eliminates this source of uncertainty

The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate

This leads to the Black-Scholes differential equation
85
shares :

+
derivative :
of consisting portfolio a up set e W






S
z S
S
t S
S t
S
S
z S t S S
c
c

o o
c
c
+ o
|
|
.
|


\
|
o
c
c
+
c
c
+
c
c
= o
o o + o = o
1
2 2
2
2
The Derivation of the Black-Scholes
Differential Equation
86

by given is time in value its in change The

by given is portfolio the of value The
S
S
t
S
S
o
c
c
+ o = H o
o
c
c
+ = H
H
The Derivation of the Black-Scholes
Differential Equation
87
The Derivation of the Black-Scholes
Differential Equation

: equation al differenti Scholes - Black the get to
equations these in and for substitute We

Hence rate.
free - risk the be must portfolio the on return The
r
S
S
S
rS
t
S
t r
=
c
c
o +
c
c
+
c
c
o o
o H = H o
2
2
2 2
88
The Black-Scholes Formula

T d
T
T r K S
d
T
T r K S
d
d N S d N e K p
d N e K d N S c
rT
rT
o =
o
o +
=
o
o + +
=
=
=

1
0
2
0
1
1 0 2
2 1 0
) 2 /
2
( ) / ln(
) 2 /
2
( ) / ln(
) ( ) (
) ( ) (

where


89
Assumptions underlying the Black & Scholes Model
(i) Stock price behaviour corresponds to lognormal behaviour
with constant and .

(ii) There are no transaction costs or taxes and securities are
perfectly divisible.

(iii) There are no dividends during the life of the option.

(iv) There are no riskless arbitrage opportunities.

(v) Securities trading is continuous.

(vi) Investors can borrow or lend at the same risk-free rate of
interest.

(vii) The short-term risk-free rate of interest, R is constant.
90
Why stock return doesnt find a place in formula
Consider a portfolio of a stock and a long put. The bad news in stock
will be good news for put.

If the gain is exactly offset by a loss, the investor is holding a position
in a riskless asset. A situation similar to holding a T-bill with return
known in advance.

The option holder has a claim on which he can loose very little. But he
can gain a great deal. Volatility matters!

Seller of the option likes stable conditions. Simply pocket the
premiums.

How does an investor estimate whether an option is cheap, expensive
or right. With the B & S formula, look at the implied volatility. It is now
upto the investor to judge if the volatility estimate is low, high or just
about right.


91
In a certain world, if investors knows that a call will finish out of
money, the value of a call will be 0.

if investors knew that a call would finish in the money, the value of
the call at expiration would be = S
T
X

Its value today would be =(S
T
X)*exp(-RT)

C
0
= S
0
X*exp(-RT)

Compare this with the B & S formula.

You just need to multiply this by N(d1) & N(d2) and get the B & S
model.

N(d1) is the hedge ratio.

N(d2) equals the probability that call would finish in the money.
Why stock return doesnt find a place in formula
92
One of the assumptions of the model is that stock prices follow a
diffusion process.

S/S = t + Z

= Expected return on the stock per unit of time.

= Standard deviation of the stocks return during unit of time.

Z is a random variable with a mean of 0 and variance of t. Z has a
mean of 0 and a variance of t.

For example if = 0.05% per day. If it was compounded for 365 days
the return would be 20.016%/year.

= 0.0261725/day; the variance of the stock daily return is 0.000685
and the annual variance is 0.250025 and the standard deviation is
0.500025.

The important thing to note here is that standard deviation is
proportionate to square root of the time.
Why stock return doesnt find a place in formula
93
The Distribution of stock returns:

Since a stock price cant fall below 0 (shareholders have limited
liability), the stock returns dont follow a normal distribution but a log
normal distribution.

What this means is that ln(1 + stock return) i.e. ln(S
T
+ 1/S
T
) is normally
distributed.

If a stock price becomes 0, what it means is that ln(0) is -, which is
the left tail of any normal distribution.

Secondly, the lognormal distributions are positively skewed.

Positive skewness is characterised by the extended right tail.

The natural logarithms of relative prices, ln(S
T2
/S
T1
) are continually
compounded returns and these are normally distributed if the stock
follows a diffusion process.


Why stock return doesnt find a place in formula
94
Summary:

Stock follows a diffusion process.

Returns over a given interval of time are lognormally distributed
whereas continuously compounded returns are normally distributed.

If the stock follows a diffusion process, then its return variance is
proportional to time and the standard deviation of its returns is
proportional to the square root of time.

The diffusion process assumes that the variance of the stocks return
is constant, regardless of the stock price.

There is however considerable evidence that stock prices are more
variable at lower prices than at higher prices. This can be attributed to
a firms capital structure. As the price declines the leverage increases
and with it the variance of the stock.
Why stock return doesnt find a place in formula
95
Understanding Volatility
The volatility of a stock is measured by our uncertainty about the
returns provided by a stock.

Typical volatilities of the stocks are in the range of 20% to 40% per
annum.

B & S model assumes a continuous framework and therefore while
computing returns we use ln(S
T+1
)/S
T


We take these observations for 20-24 previous trading days typically
to estimate historical volatility of the daily returns from the underlying.

These returns are then annualised by multiplying by sqrt(252) i.e.
multiplied by app. number of trading days in a year to get an
annualised number.

This annualised number is then plugged in the B & S model to
estimate theoretical value of the options.
96
Understanding Volatility
The formula for variance is: (Xi
2
)/(n-1) - [(Xi
2
)]/{[n][n-1]}

Variance = E(Xi
2
) - [E(Xi)]
2

In simple words volatility can be looked upon as the speed of the
market.

If we assume that prices are distributed along a normal distribution
curve then value of the underlying depends upon where the peak of
the curve is located & the value of the option depends upon how fat
the curve spreads out.

Recall from the normal distribution curve property that
+/- 1 covers 68.3% of the curve
+/- 2 covers 95.4% of the curve
+/- 3 covers 99.7% of the curve

Volatility tells us not only about the speed of the market but also
about the probability that the option will end up in the money.
97
Implied Volatility
Volatility that forces the value obtained from an option pricing model
(B & S) to equal the current market price of the option.

The model is said to imply the level of volatility in the underlying asset
and thereby reveal to the market , what investors expect the volatility
of the asset to be over the remaining life of the option.

IV can also looked upon as the consensus volatility among the market
participants.

IV can be much more useful in quoting option prices, because
regardless of the underlying price, time to expiration, or whether the
option is put/call, IV is suppose to be of the underlying asset.

We can easily compute IV on the excel sheet, otherwise for ATM
options a rough formula is IV = C * sqrt(2)/ S*sqrt(T)

Sometimes option prices can reflect information about the
fundamental value of the underlying that is not immediately reflected
in the price of the stock itself, implying that the actual stock prices
tend to move in the direction implied by the option prices.
98
Volatility Smile
Plot of the implied volatility of an option as a function of its strike price
is known as volatility smile.

Please remember here we are talking about the volatility of the
underlying and how the volatility of the underlying can be related to
the strike prices.

The volatility smile should be the same whether calculated from call
options or put options.

Possible Causes of Volatility Smile
Asset price exhibiting jumps rather than continuous change

Volatility for asset price being stochastic (One reason for a stochastic
volatility in the case of equities is the relationship between volatility
and leverage)
99
Volatility Smile for
Equity Options
Volatility
Strike
Price
Volatility Smile for
Foreign Currency
Options
Implied
Volatility
Strike
Price
100
Volatility Term Structure
Volatility term structure shows the variation of implied volatility with
the time to maturity of the option.

The volatility term structure tends to be downward sloping when
volatility is high and upward sloping when it is low.

Normally using a model whatever volatility estimates have been made,
they are multiplied by square root of time to get the volatility estimate
for the required time frame.

This is based on the assumption that daily log returns are identical
and independently distributed. The square root of time rule implies
that assumption of constant volatility.

Constant term structures are a limitation of EWMA. The reason for this
is that financial volatility tends to come in clusters, where tranquil
periods of small returns are interspersed with volatile periods of large
returns. Thus volatility term structure should mean revert, with short
term volatility lying either above or below the long term depending on
whether current conditions are of high or low volatility.
101
New Models to Estimate Volatility
2
1
2
1
2
) 1 (

+ o = o
n n n
u
Exponential Weighted Moving Average Model

In an exponentially weighted moving average model, the weights
assigned to the u
2
decline exponentially as we move back through
time.

This leads to:




i.e. the sum of previous day volatility multiplied by some weight and
recent observation multiplied by some weight.

If we solve the equation of previous day volatility it will be again time
two days before volatility and (1-) times one day before observation.

The exponential moving average is attractive as it has very few
observations to play around with i.e. previous day volatility and the
latest observation.
102
Assuming there is a big move in the market and todays observation
is very large, then our volatility measure will be revised upwards.

A low value of means giving more weight to recent observation and
vice-versa.

is also known as persistent coefficient

1 - is known as reaction coefficient

JP Morgan uses a of 0.94. The company found that using this value
across various market variables gives value of estimated volatility
close to the realised volatility.

Here the realised variance rate was calculated by measuring the
returns on the subsequent 25 days.



New Models to Estimate Volatility
103
GARCH Model (1,1)
GARCH stands for Generalised Autoregressive Conditional
Heteroscedasticity. The last term means changing variance. Here
the volatility is measured by giving weights to the last volatility, the
recent observation and the long-term variance average.

Here again the sums of the weights equal 1. This model takes into
account the fact that over the long run, the variance tends to be
pulled back to a long term variance. In practice, variance tends to be
pulled back to long term variance and to that extent this model has
more theoretical basis.
2
1
2

=
n
2
1
|o + o o
n
n
u +

VL
New Models to Estimate Volatility