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Derivatives Models on Models PDF

386 Pages·2007·3.24 MB·English
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Derivatives Models on Models Derivatives Models on Models Espen Gaarder Haug Copyright2007by JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester, WestSussexPO198SQ,England Telephone(+44)1243779777 Email(forordersandcustomerserviceenquiries):[email protected] VisitourHomePageonwww.wileyeurope.comorwww.wiley.com AllRightsReserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedinany formorbyanymeans,electronic,mechanical,photocopying,recording,scanningorotherwise,exceptunderthetermsof theCopyright,DesignsandPatentsAct1988orunderthetermsofalicenceissuedbytheCopyrightLicensingAgency Ltd,90TottenhamCourtRoad,LondonW1T4LP,UK,withoutthepermissioninwritingofthePublisher.Requeststo thePublishershouldbeaddressedtothePermissionsDepartment,JohnWiley&SonsLtd,TheAtrium,SouthernGate, Chichester,WestSussexPO198SQ,England,[email protected],orfaxedto(+44)1243770620. Photographs,cartoonsandpaintings2007byEspenGaarderHaug. Designationsusedbycompaniestodistinguishtheirproductsareoftenclaimedastrademarks.Allbrandnamesand productnamesusedinthisbookaretradenames,servicemarks,trademarksorregisteredtrademarksoftheirrespective owners.ThePublisherisnotassociatedwithanyproductorvendormentionedinthisbook. Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.It issoldontheunderstandingthatthePublisherisnotengagedinrenderingprofessionalservices.Ifprofessionaladvice orotherexpertassistanceisrequired,theservicesofacompetentprofessionalshouldbesought. OtherWileyEditorialOffices JohnWiley&SonsInc.,111RiverStreet,Hoboken,NJ07030,USA Jossey-Bass,989MarketStreet,SanFrancisco,CA94103-1741,USA Wiley-VCHVerlagGmbH,Boschstr.12,D-69469Weinheim,Germany JohnWiley&SonsAustraliaLtd,42McDougallStreet,Milton,Queensland4064,Australia JohnWiley&Sons(Asia)PteLtd,2ClementiLoop#02-01,JinXingDistripark,Singapore129809 JohnWiley&SonsCanadaLtd,6045FreemontBlvd,Mississauga,Ontario,L5R4J3,Canada Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappears inprintmaynotbeavailableinelectronicbooks. BritishLibraryCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheBritishLibrary ISBN978-0-470-01322-9 Typesetin10/12ptTimesbyLaserwordsPrivateLimited,Chennai,India PrintedandboundinGreatBritainbyAntonyRoweLtd,Chippenham,Wiltshire Thisbookisprintedonacid-freepaperresponsiblymanufacturedfromsustainableforestry inwhichatleasttwotreesareplantedforeachoneusedforpaperproduction. Contents Author’s “Disclaimer” ix Introduction x Derivatives Models on Models xv Nassim Taleb on Black Swans 1 Chapter 1 The Discovery of Fat-Tails in Price Data 17 Edward Thorp on Gambling and Trading 27 Chapter 2 Option Pricing and Hedging from Theory to Practice: Know Your Weapon III 33 1 The Partly Ignored and Forgotten History 34 2 DiscreteDynamicDeltaHedgingunderGeometricBrownianMotion 44 3 Dynamic Delta Hedging Under Jump-Diffusion 50 4 Equilibrium Models 54 5 Portfolio Construction and Options Against Options 55 6 Conclusions 63 Alan Lewis on Stochastic Volatility and Jumps 71 Chapter 3 Back to Basics: A New Approach to the Discrete Dividend Problem 79 Together with Jørgen Haug and Alan Lewis 1 Introduction 79 2 General Solution 82 3 Dividend Models 87 4 Applications 89 Emanuel Derman the Wall Street Quant 101 Chapter 4 Closed Form Valuation of American Barrier Options 115 1 Analytical Valuation of American Barrier Options 115 vi CONTENTS 2 Numerical Comparison 116 3 Conclusion 118 Peter Carr, The Wall Street Wizard of Option Symmetry and Volatility 121 Chapter 5 Valuation of Complex Barrier Options Using Barrier Symmetry 129 1 Plain Vanilla Put–Call Symmetry 129 2 Barrier Put–Call Symmetry 130 3 Simple, Intuitive and Accurate Valuation of Double Barrier Options 132 4 Static Hedging in the Real World 137 5 Conclusion 138 Granger on Cointegration 141 Chapter 6 Knock-in/out Margrabe 145 with Jørgen Haug 1 Margrabe Options 145 2 Knock-in/out Margrabe Options 146 3 Applications 147 Stephen Ross on APT 153 Chapter 7 Resetting Strikes, Barriers and Time 157 with Jørgen Haug 1 Introduction 157 2 Reset Strike Barrier Options 160 3 Reset Barrier Options 161 4 Resetting Time 162 5 Conclusion 163 Bruno Dupire the Stochastic Wall Street Quant 167 Chapter 8 Asian Pyramid Power 177 with Jørgen Haug and William Margrabe 1 Celia in Derivativesland 177 2 Calibrating to the Term Structure of Volatility 180 3 From Geometric to Arithmetic 184 4 The Dollars 185 Eduardo Schwartz: the Yoga Master of Mathematical Finance 191 CONTENTS vii Chapter 9 Practical Valuation of Power Derivatives 197 1 Introduction 197 2 Energy Swaps/Forwards 199 3 Power Options 202 4 Still, What About Fat-Tails? 209 Aaron Brown on Gambling, Poker and Trading 211 Chapter 10 A Look in the Antimatter Mirror 223 1 Garbage in, Garbage Out? 223 2 Conclusion 227 Knut Aase on Catastrophes and Financial Economics 231 Chapter 11 Negative Volatility and the Survival of the Western Financial Markets 239 Knut K. Aase 1 Introduction 239 2 Negative Volatility – A Direct Approach 240 3 The Valueof a European CallOption for anyValue – Positive or Neg- ative – of the Volatility 240 4 Negative Volatility – The Haug interpretation 242 5 Chaotic Behavior from Deterministic Dynamics 242 6 Conclusions 243 Elie Ayache on Option Trading and Modeling 247 Chapter 12 Frozen Time Arbitrage 267 1 Time Measure Arbitrage 268 2 Time Travel Arbitrage 269 3 Conclusion 273 Haug on Wilmott and Wilmott on Wilmott 277 Chapter 13 Space-time Finance The Relativity Theory’s Implications for Mathe- matical Finance 287 1 Introduction 287 2 Time dilation 290 3 Advanced stage of Space-time Finance 292 4 Space-time Uncertainty 293 5 Is High Speed Velocity Possible? 295 6 Black-Scholes in Special Relativity 299 7 Relativity and Fat-Tailed Distributions 301 viii CONTENTS 8 General Relativity and Space-time Finance 302 9 Was Einstein Right? 305 10 Traveling Back in Time Using Wormholes 307 11 Conclusion 308 Andrei Khrennikov on Negative Probabilities 317 Chapter 14 Why so Negative about Negative Probabilities? 323 1 The History of Negative Probability 323 2 Negative Probabilities in Quantitative Finance 324 3 Getting the Negative Probabilities to Really Work in Your Favor 327 4 Hidden Variables in Finance 328 5 The Future of Negative Probabilities in Quantitative Finance 329 6 Appendix: Negative Probabilities in CRR Equivalent Trinomial Tree 330 David Bates on Crash and Jumps 335 Chapter 15 Hidden Conditions and Coin Flip Blow Up’s 343 1 Blowing Up 343 2 Coin Flip Blow Up’s 344 Peter Ja¨ckel on Monte Carlo Simulation 349 Index 359

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Derivatives Models on Models takes a theoretical and practical look at some of the latest and most important ideas behind derivatives pricing models. In each chapter the author highlights the latest thinking and trends in the area. A wide range of topics are covered, including valuation methods on
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