13.

APRIL 2023

INDIVIDUAL ASSIGNMENT
DERIVATIVES & FINANCIAL ENGINEERING

DIAA EDDIN SAEED

201309832
Part 1.

1.

The Black-Scholes model is a widely used mathematical model for pricing options.
The model is based on several assumptions about the underlying asset, including
those related to the distribution of returns and volatility.

One of the key assumptions of the Black-Scholes model is that the returns of the
underlying asset follow a lognormal distribution. This assumption is based on the
efficient market hypothesis, which suggests that the market reflects all available
information about the underlying asset and that the price changes are normally
distributed. Under this assumption, the natural logarithm of the asset's price is
normally distributed. However, in reality, the lognormal distribution assumption may
not hold for all underlying assets.

Some assets may have skewed or heavy-tailed distributions of returns, which can
result in inaccurate option pricing using the Black-Scholes model. This is because the
model is based on the assumption that the returns of the underlying asset are normally
distributed. When the returns have a skewed distribution or are heavy-tailed, the
Black-Scholes model may overestimate or underestimate the value of the option.

Another key assumption of the Black-Scholes model is that the volatility of the
underlying asset is constant and known. This means that the standard deviation of the
asset's returns is assumed to be the same for all time periods. This assumption is
based on the idea that the volatility of the asset is a function of its inherent risk and is
not influenced by other factors such as market conditions or investor sentiment.

However, in practice, the constant volatility assumption may not hold. The volatility of
the underlying asset may change over time due to changes in market conditions or
other factors. For example, during periods of economic uncertainty, the volatility of
the underlying asset may increase. This may result in option prices that are over- or
undervalued based on the model's assumptions.

In addition, there are some other assumptions that Black-Scholes model rely in his
model, such as:

• No transaction costs.

The Black-Scholes model assumes that there are no transaction costs associated
with trading options. This assumption means that the cost of buying or selling an
option is zero, and there are no bid-ask spreads or commissions involved.

• No dividends or other payouts.

The Black-Scholes model assumes that the underlying asset does not pay any
dividends or other payouts during the life of the option. This means that the price of
the underlying asset does not change due to dividends or other payouts during the
life of the option.

• European-style options.

The Black-Scholes model assumes that the option is a European-style option, which
means that the option can only be exercised on the expiration date. This assumption
simplifies the option pricing model, as there is no need to consider the possibility of
early exercise.

The Black-Scholes model is a widely-used mathematical framework for pricing options

contracts. While the model makes a number of simplifying assumptions that may not
fully capture the complexity of financial markets, it has been widely used and has been
found to be reasonably accurate in practice. These assumptions allow for the
calculation of a "fair" price for an option, which is the price at which the option should
trade in a perfectly efficient market.

However, Black-Scholes has several limitations. For example, it assumes that the
underlying asset price follows a lognormal distribution, which may not hold in all cases.
In practice, asset prices may follow other distributions, such as a normal or skewed
distribution, which can affect the accuracy of the model's predictions. Additionally, the
model assumes that volatility is constant and known, but in practice, volatility can be
difficult to predict and can change over time as mentioned earlier.

Moreover, the Black-Scholes model does not account for transaction costs, taxes, or
other frictions that can impact trading in financial markets. In reality, trading can be
expensive, and taxes can significantly affect the profitability of trading strategies. The
model also assumes that there are no market frictions, such as liquidity risk, which
can impact trading decisions.

Finally, the Black-Scholes model does not account for changes in market sentiment
or unexpected events that can impact market dynamics. For example, sudden
changes in market conditions, such as the outbreak of a pandemic or a geopolitical
crisis, can significantly impact the prices of financial instruments and may render the
model's predictions inaccurate.

Despite these limitations, the Black-Scholes model is still widely used in the financial
industry for option pricing and hedging. There have been several extensions and
modifications to the model to account for non-normal return distributions or time-
varying volatility.
For example, the Heston model is an extension of the Black-Scholes model that
includes a stochastic volatility component. This model assumes that the volatility of
the underlying asset is not constant but rather follows a random process that can
change over time. The stochastic volatility component allows for a more accurate
pricing of options when the volatility of the underlying asset is not constant.

Other models such as the GARCH model or the stochastic volatility model account
for time-varying volatility. These models assume that the volatility of the underlying
asset is a function of its past returns and can vary over time.

In conclusion, while the Black-Scholes model is a useful tool for option pricing, its
assumptions related to the distribution of returns and constant volatility may not
always reflect the reality of financial markets. Therefore, it is important to use the
model as a tool rather than relying solely on it for investment decisions. It is also
essential to perform sensitivity analyses to assess the impact of deviations from the
model's assumptions on the option prices. By doing so, investors can make more
informed decisions about their investments and minimize the risk of losses. Ultimately,
successful trading and investment decisions require a combination of market
knowledge, experience, and a deep understanding of financial instruments and risk
management.

2.

Implied volatility (IV) is a measure of the market's expectation of the future volatility of
an underlying asset. It is a key input in options pricing models such as the Black-
Scholes model, which is used to calculate the theoretical value of an option. It is
derived from the market price of an option, along with other variables such as the
underlying asset price, strike price, time to expiration, and risk-free interest rate. It
represents the volatility value that, when input into the pricing model, would produce
the current market price of the option.

The volatility smile and smirk are patterns that can be observed in the implied volatility
surface of options. The implied volatility surface is a three-dimensional plot that shows
how the implied volatility of options varies with respect to the strike price and time to
expiration. However, the volatility smile and smirk suggest that the market perceives
the distribution of returns to be fatter-tailed than predicted by the lognormal
distribution assumed by the Black and Scholes model. This means that the market
perceives a higher probability of extreme price movements than predicted by the
model, especially for out-of-the-money and in-the-money options.

The volatility smile refers to the pattern where the implied volatility of out-of-the-money
options is higher than the implied volatility of at-the-money options, and the implied
volatility of in-the-money options is lower than the implied volatility of at-the-money
options. This results in a "smile" shape when the implied volatility surface is plotted.
The volatility smile is often observed in the options markets, particularly in equity index
options, and is usually attributed to the market's perception of a higher probability of
extreme events (such as market crashes) in the future.

The volatility smirk, on the other hand, is a pattern where the implied volatility of at-
the-money options is higher than the implied volatility of out-of-the-money options,
and the implied volatility of in-the-money options is lower than the implied volatility of
out-of-the-money options. This creates a "smirk" shape in the implied volatility surface.
The volatility smirk is less common than the volatility smile, and is usually observed in
options on individual stocks. It is often attributed to the market's perception of a
greater uncertainty in the future earnings and cash flows of individual companies, as
opposed to broader market indices.

Both the volatility smile and smirk have important implications for options pricing and
risk management, as they can affect the fair value of options and the hedging
strategies used by traders and investors.

IV is important because it reflects the market's expectation of the future volatility of

the underlying asset. If the market expects that the underlying asset will become more
volatile in the future, the IV will increase. Conversely, if the market expects that the
underlying asset will become less volatile, the IV will decrease.

The Black-Scholes model assumes that the underlying asset follows a lognormal
distribution, and the IV is used as the input to calculate the option price based on this
assumption. The IV can also be used as a measure of the market's perception of risk,
as a higher IV implies a greater uncertainty and potential for larger price swings in the
underlying asset.

In summary, IV is important because it is a key input in the Black-Scholes formula,

which is used to price options and other derivatives. It is also a useful gauge of the
market's perception of future volatility and risk.

As referred to earlier, Black and Scholes model assumes that the volatility of an
underlying asset is constant over time. This assumption is known as constant volatility
or Black-Scholes volatility. However, empirical evidence suggests that the volatility of
an asset can vary over time and that it can be affected by different factors such as
economic events, news, and market conditions. As a result, new models have been
developed to account for this variability.
Stochastic volatility models, on the other hand, assume that the volatility of an
underlying asset is not constant but varies over time in a random manner. These
models take into account the uncertainty and randomness of the market by
incorporating a stochastic process for the volatility of the asset. This means that the
volatility is not known in advance, but it evolves over time according to a mathematical
formula that captures the underlying dynamics of the market.

Stochastic volatility models are more flexible and realistic than the Black and Scholes
model because they can better capture the dynamics of financial markets. They also
provide more accurate estimates of option prices, especially for longer-term options
or when there are sudden changes in the market.

Overall, the Black and Scholes model is a useful tool for pricing options, but it has
limitations due to its assumption of constant volatility. Stochastic volatility models are
more advanced and provide a more accurate representation of the underlying market
dynamics.
Part 2.

1.

Using the Monte Carlo simulation equation (𝑆𝑡+1 = 𝑆𝑡 + 𝑟 ∆𝑡 𝑆𝑡 + 𝜎 √∆𝑡 𝑆𝑡 . 𝜀𝑡+1).

Plugging all the parameters in the equation it gives us a call option price of
approximately 29.85. as we know that there is some randomness in the simulation, so
the result may differ slightly each time. Increasing the simulations will get better result,
as we used N=1000 simulations for 51 days, and then we calculated the present value
of the total simulations average.

Current price "Sο" 407.602

Volatility "σ" 0.11
risk-free rate "r" 0.040706
Maturity "T" 0.140
Strike "K" 380
deltaT 0.002739726
Market Price 31.25
Call 29.85055938

2.

The market price is higher than the calculated value using Monte Carlo simulation,
and the reason for the difference between the theoretical price and the market price
could be due to a number of factors, such as:

A. Market inefficiencies or imperfections: The market price of the option may

reflect supply and demand factors that are not accounted for in the Black-
Scholes model, such as market sentiment, liquidity, or transaction costs.

B. Model assumptions: The Black-Scholes model assumes that the underlying

asset follows a lognormal distribution and that the volatility of the asset is
constant over time. However, these assumptions may not hold in reality, and
the model may not fully capture the dynamics of the underlying asset.

C. Parameter estimation errors: The parameters used in the Black-Scholes

model, such as the volatility and the risk-free interest rate, are estimated from
historical data and may not be accurate predictors of future values.
 D. Time decay and other factors: The option price is also influenced by time
decay, which reduces the value of the option as it approaches maturity, and
other factors such as dividends or changes in the underlying asset's price.

E. As mentioned earlier the randomness numbers may affect the calculated price
every time.

3.

Applying Monte Carlo simulation for the same parameters given to calculate the Gap
option with K2=390.

We have a Gap call option, and the Trigger is above the Strike K2 > K1, in this case we
need to follow Gap options rules:

In cased the maturity date price is out of the gap (Greater or lower the Gap) the option
behaves normally. In the other hand, if the maturity date price between the Gap
(between K1 and K2) we need to apply the rule (ST − K1 when ST > K2), otherwise the
payoff is 0. So, we applied this condition in all S51 simulations, and found the present
value of the payoff equal to 29.43.

Current price "Sο" 407.602

Volatility "σ" 0.11
risk-free rate "r" 0.040706
Maturity "T" 0.140
Strike "K" 380
deltaT 0.002739726
Market Price 31.25
Call 29.85055938
K2 390
Gap Call 29.42942912

The graph below shows the simulation results at maturity (day 52) only, and noticed
the majority located out of the gap, and some of them between K1 and K2.
470

460

450

440

430

420

410

400
K2 = 390
390

380

370 K1 = 380
360

350