Option pricing in a nutshell

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

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

3. Implied Volatility Asset price Payoff = 20 Average = 10 120 Payoff = 10 Average = 5 110 100 Time 90 Payoff = 0 80 Payoff = 0

4. Time to Maturity Asset price Average = 10 Payoff = 20 120 Payoff = 10 Average = 5 110 100 Time 90 Payoff = 0 80 Payoff = 0

5. 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.

6. 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?” Market Hedger Investor 1: ABC Plc price = £1. Hedger borrows £1 from market and buys 1 share. 2: Over the year the hedger pays interest on loan (say 1%) and receives dividends on ABC Plc stock (say 3%). Market 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.

7. Interest Rates and Dividends

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

9. Interest Rates and Dividends Asset price Forward price 120 Payoff = 10 110 Average = 5 100 Time Payoff = 0 90 80

10. Interest Rates and Dividends Asset price Forward price 120 Payoff = 15 110 Average = 7.5 100 Time Payoff = 0 90 80

11. 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.

12. 5 Minutes on Numbers

13. 5 Minutes on Numbers

14. 5 Minutes on Numbers

15. 5 Minutes on Numbers

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

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

18. USD 6 year swap rates

19. GBP 6 year swap rates

20. DISCLAIMER The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley Lakeman Securities makes no guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without notice. This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended for the use of institutional and professional customers and is not intended for the use of private customers. This document is not intended for distribution in the United States of America or to US persons. This document is intended to be distributed in its entirety. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. Catley Lakeman Securities is a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. Registration Number: OC336585, FSA Reference: 484826