Applications in Option Pricing


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Applications in Option Pricing

  1. 1. Division of International Studies International Christian University Readings in International Economy and International Management: Applications in Option Pricing Autumn 2002 Instructor: Nobuya Takezawa Office: ERB II 225 Tel.: 3183 Class Hours: Thursday , 5th, 6th periods e-mail: Office Hours: Tuesday, 11:00-12:30 Course Description This course will serve as an introductory course in the application of option pricing models. All applications will revolve around the celebrated Black-Scholes model. The first half of the course will be devoted to gaining a basic understanding of the Black- Scholes model from different perspectives. The course then proceeds to look at two sets of applications: deposit insurance and credit risk analysis, and real options (for valuation). We will also touch on executive stock options as this is a relatively “hot issue” in Japan (and US), to date. The applications in this course are not necessarily in traded options instruments that we find in the market. Instead, option pricing is used as a tool to aid us in analyzing risk. The course will be a mixture of lectures, presentation, and discussion. Active participation in class discussion is highly encouraged. This course is intended for third year students. Required prerequisite: 1) One course in finance, 2) elementary statistics, 3) one semester of calculus [or equivalent] Recommended (additional) prerequisite: Additional courses in finance, courses in microeconomics/price theory, advanced statistics (and probability, econometrics). 1
  2. 2. Evaluation Evaluation is based on three parts: 1. Presentation (30%): You are asked to present papers and/or cases for a given topic outlined below. Each presentation is followed by class discussion and a summary by the instructor. 2. Research Paper [40%]. Write a summary/critique of a research paper(s) (article) of your choice. Since we only cover a limited amount material (fundamental) in this course, this project allows you to explore a topic in more depth or begin research in area not covered in class. Details to be discussed in class. The paper is due beginning of session 10. A short presentation of your findings/summary is required in session 10. List of (possible) papers for review distributed in third week of class (topics include: other real options, executive stock options, political risk, bonds, etc. ) 3. Class Participation [30%] Active but constructive participation is encouraged during lectures and discussion. Regular class attendance is part of the class participation marks. Text: John Hull, Options, Futures, and other Derivatives, 4th edition. The text is available at all major bookstores in the Tokyo area and through the website (for example, Amazon Japan: Recommend purchase of the paperback edition. The fifth edition is currently available, however, readings from text outlined below are based on the 4th edition. If you have access to an earlier edition that is fine. 2
  3. 3. Course Outline Readings in Hull based on 4th edition. Session 1: Introduction to Options (Lecture) Reading: Hull Chapter 6 (background reading), Chapter 7, Chapter 13. 4 (delta hedging) Session 2: The Dynamics of the Underlying Asset Price and the Fundamental PDE (Lecture) Reading: Hull Chapter 10, Chapter 11 Session 3: The Black-Scholes Equation, Implied Volatilities, Greeks (Lecture) Reading: Hull Chapter 12 (background reading), Chapter 11, Chapter 13 (concepts only), Chapter 17.2 – 17.5 Session 4: The Binomial Tree (Presentation) Reading: Hull Chapter 9, Chapter 16.1-16.5 Session 5: Executive Stock Options L. Meulbroek, The Efficiency of Equity-linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options, Financial Management, 2001. J. Carpenter, The Exercise and Valuation of Executive Stock Options, J. Financial Economics, 1998. Session 6: Real Options (Presentation) A. Damodoran, The Promise of Real Options, J. Applied Corporate Finance, 2000. W.C. Kester, Today`s Options for Tomorrow`s Growth, Harvard Business Review, 1984. L. Trigeorgis, Introduction and Overview (Chapter 1), Real Options, MIT Press,1996. Laura Martin (Case) Session 7: Valuation and Real Options (Presentation) T. Luherman, Investment Opportunities as Real Options: Getting Started on the Numbers, Harvard Business Review, 1998. MW Petroleum (Case) 3
  4. 4. Session 8: Deposit Insurance (Presentation) R. Merton, An analytic derivation of the cost of deposit insurance and loan guarantees, J. Banking and Finance, 1977. E. Ronn and A. Verma, Pricing risk-adjusted deposit insurance: an option based model, J. Finance, 1986. R. Sato, R. Ramachandran, B. Kang, Risk-adjusted deposit insurance of Japanese Banks, in Japan, Europe, and International Financial Markets, eds. R. Sato, R. Levich, R. Ramachandran, CUP, 1994. Session 9: Credit Risk and the KMV model (Presentation) 森平 爽一郎、 信用リスクの測定と管理::第三回」 証券アナリストジャーナル』 「 『 2000. 森平 爽一郎、 「信用リスクの測定と管理:第四回」 『証券アナリストジャーナル』 2000. Session 10: Present Paper(s) of Choice Research Paper Due Beginning of Session 10 4