Option pricing in a nutshell Catley Lakeman Winter Offsite – January 2014

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

Implied Volatility Payoff = 20 Payoff = 10 Payoff = 0 Asset price Time Average = 5 Average = 10

Time to Maturity Payoff = 20 Payoff = 10 Payoff = 0 Asset price Time Average = 5 Average = 10

Interest Rates and Dividends These affect the forward price. The forward price of an asset is the price at which the hedger can sell the asset at a specified time in the future and expect to make or lose no money. It is not the expected price of the asset at that point. 5

Interest Rates and Dividends “I want to buy 1 ABC Plc Share from you in 1 year’s time. At what price will you sell it to me at that point?” 6 1: ABC Plc price = £1. Hedger borrows £1 from market and buys 1 share. Market HedgerInvestor 2: Over the year the hedger pays interest on loan (say 1%) and receives dividends on ABC Plc stock (say 3%). 3: After 1 year hedger pays back the loan and sells the stock to client. Hedger can sell the stock at 98p and still break even. So 98p is the forward price.

Interest Rates and Dividends 7

December Future = 6513 points. FTSE level = 6744 points. Difference = 3.42% is the “at the money forward” FTSE level. This is the important level when pricing options, NOT the current spot level. 8

Interest Rates and Dividends Payoff = 10 Payoff = 0 Asset price Time Average = 5 Forward price

Interest Rates and Dividends Payoff = 15 Payoff = 0 Asset price Time Average = 7.5 Forward price

Recap Higher vol = more chance of getting further away from strike. More time = more chance of getting further away from strike. Interest and dividends impact forward price. 11

5 Minutes on Numbers 12

5 Minutes on Numbers 13

5 Minutes on Numbers 14 Index LevelProbabilityOption PayoffContibution to Option Price 100% - 105%7.02%2.5%0.18% 105% - 110%6.80%7.5%0.51% 110% - 120%12.21%15%1.83% 120% - 140%16.11%30%4.83% 140% - 180%7.63%60%4.58% Total11.93%

5 Minutes on Numbers 15

MTM and the Greeks Delta = sensitivity to asset price movement Vega = sensitivity to volatility movement Rho = sensitivity to interest rate movement 16

Summary Time and volatility have a similar affect Interest rates and dividends build the forward We do this all the time! 17

USD 6 year swap rates 18

GBP 6 year swap rates 19

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