The equity derivatives market has witnessed significant growth over the past few decades after the publication of the famous option pricing paper by Black and Scholes in 1973 – both in terms of trading volumes and varieties of product payoff to the investor. The market crash on 19 October 1987 (Black Monday) marked another turning point when option traders started to realise that the assumption of flat volatility surface implied by the Black–Scholes option model was no longer valid. The observation of volatility skew in the equity options market led to the development of the local volatility model by Derman and Kani and Dupire independently in 1994. Since then, equity derivatives contracts traded in the market have grown beyond simple option contracts to include complex payoffs – for example, barrier options, cliquets, auto-callables, variance swaps, VIX futures and options and so on.
Large growth in the equity derivatives market has been driven by many factors; one important factor is increased liquidity in exchange listed equity futures and options. Market makers use these instruments to hedge other complex derivatives products they offer to the investor. Good liquidity in these hedging instruments would lower the cost of hedging and make these more complex derivatives products economically appealing.
Investors’ need for flexibility to manage their portfolios leads to many innovative derivatives products. For example, market demand for more leverage than vanilla options triggers the innovation of barrier options. Another example: investors looking for enhanced yield over traditional fixed income products are attracted to various principal protected equity-linked structured notes (ELNs). VIX futures and VIX options, introduced between 2004 and 2006 on the Chicago Board Options Exchange (CBOE), is another good example of equity derivatives innovation that allows investors to implement their view using volatility trading strategies, risk management, alpha generation and portfolio diversification. Equity derivatives products are traded either on public exchanges or on over-the-counter (OTC) markets. Exchange-traded derivatives promote transparency and liquidity by providing standardised contract and market-based pricing information. In contrast, OTC derivatives are traded privately and are customised to meet the needs of investors.
Over time, the range of pricing models has grown steadily, both as new types of derivatives have been introduced and as weaknesses in previous models have been identified. It is important that firms choose models that are rich enough to capture market features of the product but not so complex that the required parameters cannot be calibrated.
- OTC Derivatives Products
- Yield enhancement principal guaranteed structure notes
- Asset liability needs from insurance companies
- Retail investor-driven products
- Corporate financing products
- Volatility hedging
- Wealth management driven products
Common Derivatives Pricing Model
- Black-Scholes-Merton option model
- Local Volatility Model
- Stochastic volatility models
- Heston model
- Stochastic Local Volatility model
- Other stochastic volatility models
Derivatives Pricing Model Implementation
Volatility Surface Model
- Spline-based smoothing method
- Market parameter based
- Arbitrage-free parameterisation