APPLICATION OF THE OPTION MARKET PARADIGM TO

THE SOLUTION OF I NSURANCE PROBLEMS

MI CHAEL G. WACEK
Abstract
The Black-Scholes option pricing formula f rom fi-
nance theory is consistent with the assumption that the
market price of the underlying asset at any future date
is lognormally distributed with time-dependent param-
eters and can be shown to be a special case of both
a more general option model and a familiar actuarial
function used in excess of loss applications. This in-
sight leads to an understanding of the similarity be-
tween options and certain insurance concepts. Because
insurance and finance have developed separately, dif-
ferent paradigms are used by the practitioners in each
field. When these paradigms are shared, a new per-
spective on risk management, product development,
and pricing, especially of insurance and reinsurance,
emerges.
1. RELATI ONSHI P OF THE BLACK- SCHOLES FORMULA AND THE
ACTUARI AL EXCESS OF LOSS FUNCTI ON
In 1973, Fischer Black and Myron Scholes published their
now classic paper entitled "The Pricing of Options and Corporate
Liabilities," [ 1 ] in whi ch they derived the option pricing formula
that bears their name. Gerber and Shiu [2] described that paper
as "perhaps the most important devel opment in the theory of fi-
nancial economi cs in the past two decades. " The advent of the
modern derivatives market is generally traced back to the intro-
duction of exchange-traded equity options in the U.S. (1973) and
the devel opment of the Bl ack-Schol es model [3].
701
702 APPLICATION OF THE OPTION MARKET PARADIGM
Bl ack and Schol es showed that under certain condi t i ons t he
current pur e pr emi um, l c t ( S ) , for a "call opt i on" to buy a partic-
ul ar asset for pri ce S, at, and onl y at, t i me t ( wher e t is t he t i me
to expi ry) is
c , ( S ) = P o " N ( d l ) - S e - r t " N ( d 2 ) , wher e
l n ( P 0 / S ) + ( r + 0 . 5 c r 2 ) t
d~ = ~r v q ' ( 1 . 1 )
d 2 = l n ( P o / S ) + ( r - 0. 5a2)t
av' 7
and wher e P0 is t he current mar ket price, r is t he ri sk-free force
of interest, a is a measur e of annual i zed pri ce volatility, and N
is t he cumul at i ve di st ri but i on f unct i on of t he st andard nor mal
di st ri but i on.
Thi s is a daunt i ng formul a, and in this f or m it pr ovi des little
i nsi ght into t he under l yi ng opt i ons pri ci ng pr obl em. One of t he
key poi nt s of this paper is that For mul a 1.1, t he Bl ack- Schol es
formul a, is actually a special case of a fami l i ar actuarial f unct i on
wri t t en in an unf ami l i ar form. Thi s will lead us to some i mpor t ant
i nsi ght s about bot h opt i ons and i nsurance.
Consi der that t he pure pr emi um of a call opt i on exerci sabl e
onl y on t he .expiry dat e (a "Eur opean" opt i on) depends on t he
mar ket ' s current opi ni on about t he probabi l i t y di st ri but i on of t he
mar ket pri ce of t he under l yi ng asset on t he expi ry date. If t he
opt i on exerci se pri ce is S, t he opt i on will onl y be exerci sed in
t he event t he mar ket pri ce at expi ry exceeds S. Its value in t hese
ci r cumst ances will be the amount by whi ch t he mar ket pri ce
exceeds S. In ot her ci rcumst ances, t he opt i onhol der will let t he
IFi nanci al economi st s use the term "price" or "premi um. " However, to make clear to
actuarial readers that there is no embedded charge for risk or expenses in the Bl ack-
Scholes valuation, we shall use the actuarial term "pure premi um. "
APPLICATION OF THE OPTION MARKET PARADIGM 7 0 3
option expire unexercised and, if he wants to own the asset, buy
the asset at the market price. The option to buy the asset at a
hi gher than market price will be worthless. The value of the op-
tion at expiry is the probabi l i t y-wei ght ed average of all possible
expiry scenarios.
Suppose the probability distribution of market prices at expiry
is represented by the r andom variate x. Then the expect ed value
of the option at expiry is
f s
~(X - S) Future Value [ ct ( S) ] = f ( x ) d x . (1.2)
The expression on the right hand side of Formul a 1.2 is t h e f u t u r e
v a l u e of the option pure premi um, since x is defined for the
expiry date, whi ch is in the future. Its present value, di scount ed
at the risk-free interest rate, 2 is
f s
~(x S) (1.3)
c t ( S ) = e - r t _
f ( x ) d x .
Now compare Formul as 1.1 and 1.3. Formul a 1.1, the Bl ack-
Scholes formula, depends on the assumption that market prices
are l ognormal l y distributed. Formul a 1.3 is more general and has
no embedded distributional assumption. However, if the variate
x in Formul a 1.3 is assumed to be l ognormal and the correct
2Thi s is j us t i f i ed on t he bas i s t hat us i ng any ot her rat e woul d open t he door to r i s k- f r ee
ar bi t r age profi t s. It is pos s i bl e to cr eat e a r i s kl es s por t f ol i o by he dgi ng a l ong pos i t i on
in t he unde r l yi ng as s et by sel l i ng shor t an appr opr i at e n u mb e r of call opt i ons on t he
unde r l yi ng asset . Be c a us e it is r i skl ess, t hi s he dge d por t f ol i o mu s t ear n t he r i sk- f r ee rat e
o f ret urn. However , for t hi s to be t r ue ( and it mu s t be t rue to avoi d r i sk- f r ee ar bi t r age
pr of i t oppor t uni t i es) , it t ur ns out t hat t he i nt er est rat e f or di s c ount i ng t he expect ed val ue
o f t he call opt i on at expi r y mu s t al so be t he r i sk- f r ee rate. The f i nance l i t erat ure r ef er s
to t hi s p h e n o me n o n as "r i sk- neut r al val uat i on" and it appl i es to val uat i on o f all f i nanci al
der i vat i ves o f asset s whe r e sui t abl e condi t i ons for he dgi ng exi st . For f ur t her di s c us s i on
of r i sk- neut r al val uat i on and r i sk- f r ee di s count i ng, see Hul l [7].
In act uari al appl i cat i ons i nvol vi ng i ns ur ance cl ai ms ( wher e he dgi ng is not possi bl e) , it
is s ome t i me s i mpl i ci t l y r ecogni zed t hat t he r i sk- f r ee rat e is not alapropriate by di s c ount i ng
at t he r i sk- f r ee rate, and t hen addi ng a r i sk char ge to t he di s c ount e d r esul t . Thi s is
equi val ent to di s c ount i ng at a rat e l ess t han t he r i sk- f r ee rate. We have del i ber at el y
c hos e n to char act er i ze c ~ ( S ) as a "pur e p r e mi u m" to l eave t he door open to an addi t i onal
ri sk char ge wher e appr opr i at e.
7 0 4 APPLICATION OF THE OPTION MARKET PARADIGM
distribution parameters are chosen, 3 Formula 1.1 can be derived
from Formula 1.3. In other words, the Black-Scholes formula is
a special case of Formula 1.3. The proof of this is in Appendix A.
Formula 1.2, which differs from Formula 1.3 only by a present
value factor, also defines a familiar actuarial function seen fre-
quently in excess of loss insurance applications. For example, if
x is a random variate representing the aggregate value of losses
occurring during an annual period, then Formula 1.2 defines the
expected value of losses in excess of an aggregate loss amount of
S. This function is an important tool in pricing aggregate excess
or stop-loss reinsurance covers.
A second example relates to the more common type of excess
of loss coverage, where the excess attachment point S is defined
in terms of individual losses, rather than in the aggregate over a
period. In this context, if x is a random variate representing the
loss severity distribution with mean M, then Formula 1.2 defines
the expected portion of M attributable to losses in excess of S. If
the result of Formula 1.2 equals C, then C/M is the excess pure
premium factor. If N is the expected number of losses, then NC
is the expected value of excess losses.
Let us summarize what we have established. Formula 1.2
defines an important element of excess of loss pricing. It dif-
fers only by a present value factor from Formula 1.3, which de-
fines a general formula for European call option pricing. Form-
ula 1.1, the Black-Scholes formula, is a special case of Formula
1.3.
The implication of this is that excess of loss insurance and
call options are essentially the same concepts. The one deals
with insurance claims and the other deals with asset prices, but
the pricing mathematics is basically the same.
3For mul as 1.1 and 1.3 pr oduce t he s a me r esul t i f x is a I ognor mal vari at e wi t h par amet er s
( l n P 0 +rt-O.5a2t, ax/7), wher e t hi s char act er i zat i on f ol l ows Hogg and Kl u g ma n [4],
who def i ne a l ognor ma l di st r i but i on by r ef er ence to t he /~ and tr o f t he rel at ed nor ma l
di st r i but i on. See Appe ndi x A f or t he pr oof o f t hi s.
APPLI CATI ON OF THE OPTI ON MARKET PARADI GM 705
Thi s i nsi ght is pot ent i al l y t r emendousl y powerful . I f excess of
loss i nsurance and call opt i ons are essentially t he same concept
in di fferent cont ext s, t hen it must be possi bl e to translate ideas
f r om one cont ext into t he ot her cont ext . In t he r emai nder of this
paper, we will expl ore some of t he pot ent i al appl i cat i ons of t he
opt i ons mar ket par adi gm to i nsurance probl ems.
2. IMPLICATIONS OF THE EQUIVALENCE OF OPTION AND
ACTUARIAL EXCESS OF LOSS MODELS
The mat hemat i cal equi val ence of fi nance t heor y' s Bl a c k-
Schol es f or mul a and an i mpor t ant actuarial f unct i on used in ex-
cess of loss i nsurance appl i cat i ons has a number of i mpor t ant
i mpl i cat i ons for t he conver gence of i nsurance and fi nance. In
this paper we will expl ore a few of t hem.
Opt i on mar ket par adi gms can be used to t hi nk about i nsur ance
pr obl ems; and this may well lead to new i nsurance or, per haps
mor e likely, rei nsurance product s.
The mor e general actuarial excess of loss par adi gm, whi ch
encompasses and frequent l y uses di st ri but i ons ot her t han t he
l ognor mal , can be used to t hi nk about t he pri ci ng of opt i ons on
assets for whi ch mar ket pri ces are not l ognor mal l y di st ri but ed.
Taki ng t he t wo previ ous poi nt s t oget her, it is possi bl e to move
beyond exi st i ng opt i ons and actuarial par adi gms to spawn a
new one that encompasses bot h. Thi s, in turn, may l ead to
new pr oduct oppor t uni t i es for insurers, investors, or bot h.
3. THE OPTION MARKET PARADIGM
The fi nanci al market s have been t r emendousl y creative in de-
vi si ng pr oduct s and t echni ques for managi ng fi nanci al risk. Most
of this activity has occurred in what is l oosel y cal l ed t he "deriva-
tives market . " Opt i ons are at t he core of this market , and it is on
706 APPLICATION OF THE OPTION MARKET PARADIGM
FI GURE 1
EXPIRY VALUE PROFILE: CALL OPTI ON, c t ( S )
Expiry
Value
y
I
s
Underlying Asset Price at Expiry, X,
this part of the derivatives market that we will focus our attention.
Many derivative products are built around option features.
Basic Options
A "Eur opean" call option, ct(S), represents the fight but not
the obligation to buy the underl yi ng asset at, and onl y at, t i me
t at a price of S. Formul a 1.3 describes the price of such a call
option. Fi gure 1 shows its expiry value profile.
An "Amer i can" call option incorporates the right to exercise at
any t i me up to and i ncl udi ng time t. The Bl ack- Schol es formul a
applies to the pricing of European calls. In this di scussi on our
references will be to European-st yl e options unless ot herwi se
specified.
A "Eur opean" put option, pt(S), represents the fight but not
the obligation to sell the underl yi ng asset at, and only at, time t
APPLI CATI ON OF THE OPTI ON MARKET PARADI GM 707
FI GURE 2
EXPIRY VALUE PROFILE: PUT OPTION, Pt ( S)
Expi ry
Val ue
0
S
Underl yi ng Asset Price at Expiry, X t
at a pri ce of S. Fi gur e 2 shows t he expi ry val ue profi l e of a put
opt i on.
The general f or mul a for t he pri ce of a put, p t ( S ) is
s
Pt ( S) = e - r' ( S - x ) . f ( x ) d x . (3.1)
Spr e ads
The combi nat i on of t wo call opt i ons, one bought and one sold;
e.g.,
c t ( S , T ) = c t ( S ) - ct ( T) , wi t h T > S (3.2)
is known as a cal l opt i on spread.
7 0 8 APPLICATION OF THE OPTION MARKET PARADIGM
In i nsur ance parl ance, ct(S, T) refers to an excess layer, c t ( S , T)
is t he pur e pr e mi um for t he layer of T - S excess of S.
Put opt i on spreads can be defi ned in a si mi l ar way to call
opt i on spreads. 4
Implications f or Insurance Applications
Once we r ecogni ze that a call spread is t he same t hi ng as
an excess layer, a new worl d opens up. In t heory, every opt i on
and rel at ed deri vat i ve pr oduct must have an i nsurance anal ogue!
Si nce t he deri vat i ve market s have been enor mous l y creat i ve in
devel opi ng new pr oduct ideas, it shoul d be possi bl e to mi ne that
t rove of i deas for pot ent i al l y i nnovat i ve i nsurance and rei nsur-
ance pr oduct concept s.
As an exampl e of how this can be done, we will anal yze t he
deri vat i ves concept of a cylinder. Then we will reconst ruct it as
a r ei nsur ance product .
In its ext r eme f or m, a zero cost cyl i nder is creat ed by t he si-
mul t aneous pur chase of a call and sale of a put (or vi ce versa) of
equal value, usual l y at di fferent out - of - t he- money exerci se pri ces
but havi ng t he same expi rat i on date. 5 I f t he cyl i nder i nvol ves a
l ong call (i.e., t he pur chase of a call) and a short put (i.e., t he
sale of a put ), its val ue i ncreases when t he val ue of t he underl y-
i ng asset i ncreases and decreases when t he asset val ue decreases.
Thi s is a "bul l i sh" posi t i on. I f t he cyl i nder i nvol ves a short call
and a l ong put , its val ue i ncreases when t he val ue of t he underl y-
i ng asset decreases and decl i nes when t he under l yi ng asset val ue
increases. Thi s is a "beari sh" posi t i on.
4For a det ai l ed di s c us s i on o f t he ma t he ma t i c s o f call, put , and cyl i nder s pr eads , s ee
Appe ndi x B. The r e are al so a n u mb e r o f good r ef er ence books on f i nanci al der i vat i ves,
i ncl udi ng Re dhe a d [5] and Hul l [7], t hat pr ovi de mo r e c ompr e he ns i ve t r eat ment o f t he
subj ect . The r e is al so a Br i t i sh paper, Ke mp [8], whi ch e xa mi ne s t he s ubj ect f r om a mor e
act uari al per s pect i ve, a l t hough it is not par t i cul ar l y or i ent ed t owar d non- l i f e i s s ues .
5Thi s is t he ext r eme f or m. Not e t hat a cyl i nder need not be "zer o cost . " For f ur t her
di s c us s i on o f cyl i nder s and ot her opt i on c ombi na t i ons , s ee [5].
APPLICATION OF THE OPTION MARKET PARADIGM 709
FI GURE 3A
EXPIRY VALUE PROFILE: BULL CYLINDER OPTION cylt(S, T)
Expiry
Value
O- -
Underlying Asset Price at Expiry, X~
Bull and bear cylinders are defined as follows:
c y l t ( S , T) = c t ( T ) - pt ( S) , T > Po > S (bull)
- c y l t ( S , T ) = pt ( S) - ct ( T) , T > Po > S (bear)
and their expiry value profiles are shown in Figures 3A and 3B.
For an owner of the underl yi ng asset, establishing a bear
cyl i nder position partially hedges his asset position and reduces
its volatility. Since in the case of a zero cost cyl i nder the values
of the short call and long put are exactly offsetting, no money
changes hands at inception of this position. At expiration, if the
value of the underl yi ng asset is X t, the value of the cyl i nder
position is
- (X t --T), X t > T;
O, T >Xt >S ;
s - x , , s >_ x, .
710 APPLICATION OF THE OPTION MARKET PARADIGM
F I G U R E 3B
EXPIRY VALUE PROFILE: BEAR CYLI NDER OPTI ON c y l t ( S , T )
Expi r y
Val ue
O- -
Under l yi ng Asset Price at Expi ry, X t
T A B L E 1
Expiry Value Expiry Value
Asset Price of Cylinder Asset + Cylinder
X t >_ T - ( X , - T ) T
T > X, > S o x,
S > X, S - X , S
T h e h o l d e r o f t hi s p o s i t i o n g a i n s S - X t f o r s ma l l va l ue s o f X t
a n d l os e s X t - T f o r l a r ge va l ue s o f X r Fo r mi d d l e va l ue s o f X t
h e g a i n s or l os e s n o t h i n g . Hi s h e d g e d p o s i t i o n at e x p i r y o f t he
c y l i n d e r i s s u mma r i z e d i n Ta bl e 1.
I n wo r d s , t hi s i mp l i e s t ha t t he h e d g e d p o s i t i o n y i e l d s t he r e-
t u r n s o f t he u n d e r l y i n g as s et (i . e. , X t - Po) , b u t s u b j e c t t o a ma x -
i m u m l os s o f P0 - S a n d a m a x i m u m ga i n o f T - P0.
APPLICATION OF THE OFFION MARKET PARADIGM 71 1
If, rat her than owni ng the under l yi ng asset, an i nvest or has a
short posi t i on in it (i.e., it is a liability), he can partially hedge
that posi t i on wi t h a bul l cylinder.
Suppos e t he under l yi ng asset is t he ri ght to recover i nsurance
claims. To an i nsured, this is an asset (a "l ong" posi t i on). To an
insurer, it is a liability (a "short " posi t i on). Therefore, an i nsurer
coul d use a bull cyl i nder to partially hedge his exposure.
I f t here were an est abl i shed derivatives mar ket t radi ng opt i ons
on i nsurance claims, as t here is for a number of ot her fi nanci al
assets, an i nsurer woul d be able to hedge its exposur e by buyi ng
any of a variety of product s; e.g., call opt i ons, call spreads, bull
cyl i nders, or bull cyl i nder spreads. At present , t here is onl y a l i m-
ited derivatives mar ket for opt i ons on i nsurance cl ai ms (namel y,
t he excess of loss rei nsurance market ) and, broadl y speaki ng, it
offers onl y one product : t he call spread. 6 One of t he key t hemes
of this paper is that concept ual l y t here is no reason why t he rein-
surance mar ket coul d not offer si mi l ar pr oduct s to t hose f ound
in t he broader derivatives market.
Now let us consi der how t he cyl i nder concept , whi ch has t he
advant age of l ower initial cost to t he buyer compar ed to a si mpl e
call opt i on, mi ght be t ransl at ed into a rei nsurance pr oduct . To
illustrate one way this mi ght work, first i magi ne a hi gh level
excess of loss l ayer with a ret ent i on of T i and a limit of T 2 - T 1.
The mar ket pr emi um, i gnori ng all expenses, for convent i onal
cover age is c t ( T 1 , 7"2).
To creat e t he cyl i nder t ype structure, we need to i nt r oduce a
feat ure equi val ent to t he sale of a put. Consi der a second, un-
rei nsured, l ayer of S 1 - S 2 excess of S 2 wi t h i n t h e c ompa ny' s
rei nsurance ret ent i on, whi ch will f or m t he basis of t he requi red
put spread. Let p t ( S 1 , S 2 ) denot e the val ue of this put spread.
6At t he t i me t hi s paper was wri t t en, t he Chi c a go Boar d o f Tr a d e ' s ef f or t s to cr eat e a
mar ket for opt i ons on U. S. cat as t r ophe l osses had not yet pr oduced s i gni f i cant capaci t y.
712 APPLICATION OF THE OPTION MARKET PARADIGM
A r ei nsur ance cyl i nder spread can be creat ed by t he pur chase
by a cedi ng company of t he hi gh level excess of loss l ayer at a
cost of c t ( T l , T 2) and t he equi val ent of t he sale of a put spread
on t he l ower l ayer at a pri ce of p t ( S i , S 2 ) . ( T h i s is not neces-
sarily a zero cost cylinder. ) The pr emi um out l ay of t he ced-
i ng company at t he begi nni ng of t he cont ract woul d t hen be
c t ( T 1 , T 2 ) - Pt ( S1 , $ 2 ) . Si nce t he rei nsurer may requi re a mi ni mum
initial pr e mi um of M > 0, it may be necessary to allow t he ratio
of put s to calls to be di fferent f r om one. I f this ratio is represent ed
by Q, t he initial pr e mi um is gi ven by
M = c t ( T 1 ,T2) - Qp t ( S 1 ,$2).
Under this st ruct ure, t he pr e mi um of c t ( Ti , T2) buys exact l y t he
same excess pr ot ect i on agai nst large cl ai ms as t he convent i onal
rei nsurance provi des. The pr e mi um credit of Q p t ( S 1 , S 2 ) embed-
ded in t he initial pr e mi um represent s t he sale of a put spread
on t he l ower l ayer by t he cedi ng company to t he reinsurer, t he
final val ue of whi ch will be settled as an addi t i onal pr e mi um of
mi n(Q(Sl - Xt ) , Q( SI - $ 2 ) ) when cl ai m exper i ence is known.
Let us now put s ome number s to it. Let
c,(T~,T2) = $2, 500, 000,
p t ( S i , S 2 ) = $3, 889, 000,
Q = 45%,
S l = $15, 000, 000, and
S 1 - S z = $5, 000, 000.
Then t he initial pr e mi um is cal cul at ed as follows:
M = c t ( T l , T 2) - Q . p , ( S 1 ,$2)
= $2, 500, 000 - (. 45)($3, 889, 000)
= $750, 000.
APPLICATION OF THE OPTION MARKET PARADIGM
TABLE 2
713
Initial Additional Total
Claims X t Premium Premium Premium
Xt < S 2 $750 $2,250 $3,000
S 2 < X t < S 1 $750 (45%)($15,000 - X:) Slides $750 to $3,000
S 1 < X, $750 0 $750
Note: Premium figures in thousands.
At expi r y of t he cont r act (or at such t i me as agr eed) , an addi t i on-
al pr emi um, A, equal to t he expi r y val ue of t he "put spr ead" is
due:
A = mi n[ Q( S l - X t ) , Q ( S l - $2)]
= l esser of : ( . 45) ( $15, 000, 000- x t ) and (. 45)($5, 000, 000).
The total pr e mi um under a "cyl i nder " r ei nsur ance st r uct ur e de-
pends on t he final cost of cl ai ms, X t, as shown in Tabl e 2.
Thi s compar es to t he fi xed pr e mi um of $2, 500, 000 unde r t he
convent i onal cont r act and is shown gr aphi cal l y on Fi gur e 4. In
t he cyl i nder st ruct ure, t he cedi ng c ompa ny pays a hi gher pre-
mi um f or its cover age of T 2 - T i excess of T 1 when t he cl ai m ex-
per i ence in t he r et ai ned subl ayer of S 1 - S 2 excess of S 2 is good
(up to $3, 000, 000 versus $2, 500, 000). It pays a l ower pr e mi um
when cl ai m exper i ence in that l ayer is bad ( $750, 000 ver sus
$2, 500, 000). In ot her words, t he c ompa ny pays mor e when its
net cl ai ms exper i ence is rel at i vel y good and it can af f or d hi gher
r ei nsur ance pr emi ums , and less when its net is poor and it can
l east af f or d t he bur den of even nor mal r ei nsur ance pr emi ums .
Thi s is i l l ust rat ed gr aphi cal l y in Fi gur e 5 in t er ms of t he ef f ect
on under wr i t i ng profi t . Thi s pr e mi um st ruct ure is mor e ef f ect i ve
in r educi ng t he vol at i l i t y of a cedi ng c ompa ny' s net under wr i t i ng
resul t t han t he convent i onal st ruct ure. Because of this stability,
it mi ght appeal to r ei nsur ance buyer s who use excess of loss
cover age to r educe under wr i t i ng volatility.
714 A P P L I C A T I O N O F T HE O P T I O N MA R K E T P A R A D I G M
FIGURE 4
ILLUSTRATION OF "CYLINDER" REINSURANCE PREMIUM
STRUCTURE
"~' 3 . 5
C
0
= 3
E
E_ 2 , 5
. m
E
2
t "
1.5
m
_ 1
1
t ~ 0 , 5
R
w
L
O " . . . . . . . . . . . .
L L ;
0 5 10 15 20
C a t a s t r o p h e L o s s ( m i l l i o n s )
Conv ent i onal
--411--
Cyl i nder
FIGURE 5
ILLUSTRATION OF "CYLINDER" REINSURANCE EFFECT ON
UNDERWRITING PROFIT
20
c -
o
, D
E

0.
O~
" 0
t -
15
10
m
5 10 15
C a t a s t r o p h e L o s s ( mi l l i o n s )
Conv ent i onal
Cylinder
,
20
APPLICATION OF THE OPTION MARKET PARADIGM 715
The flip si de of this is that t he r ei nsur er ' s volatility is in-
creased. Why woul d a rei nsurer be wi l l i ng to offer such a struc-
ture, whi ch reduces pr emi ums when cl ai ms are hi gher ? The an-
swer is that, in t he cont ext of a r ei nsur er ' s diversified port fol i o,
t he i ncr ement al volatility will be small, whi l e t he extra bene-
fit to t he r ei nsur er ' s cust omer may wel l st rengt hen t he overal l
rei nsurance rel at i onshi p. The rei nsurance mar ket has somet i mes
been criticized for selling "of f t he shel f" pr oduct s that it want s
to sell, rat her t han what cedi ng compani es actually want to buy.
In classes of rei nsurance wher e rei nsurers can sell as much off-
t he- shel f pr oduct as they want, t here exists little or no pr essur e
for t hem to i nt r oduce i nnovat i ve st ruct ures like t he f or egoi ng
exampl e. However, to t he ext ent s ome rei nsurers want to pur-
sue a mor e cust omer - f ocused strategy or si mpl y feel compet i t i ve
pressure, pr oduct i nnovat i on will i ncreasi ngl y begi n to emer ge.
I ndeed, t he aut hor is aware of at least one maj or rei nsurer t hat
has devel oped a pr oduct that has features si mi l ar to this exampl e.
The cyl i nder is onl y one exampl e. Ther e are undoubt edl y
many ot her pract i cal i nsurance and rei nsurance pr oduct s wait-
ing to be di scover ed by expl ori ng t he derivatives pr oduct para-
di gm.
4 . P RI CI NG OP TI ONS WHE N F UT URE PRI CES ARE NOT
L OGNOR MAL
The Bl ack- Schol es model relies on t he assumpt i on that mar-
ket pri ce changes over any finite t i me interval (expressed by t he
ratio Pn/P~_I) are l ognor mal l y di st ri but ed. Si nce t he pr oduct of
l ognor mal variates is also l ognor mal , this assumpt i on leads to t he
conveni ent concl usi on that fut ure mar ket pri ces are also so dis-
t ri but ed wi t h predi ct abl e t i me- dependent paramet ers. The beaut y
of this is that t he same f r amewor k can be used to det er mi ne t he
pur e pr e mi um pri ce for a one mont h, six mont h, or one year
opt i on, or one for any ot her t i me peri od.
716 APPLICATION OF THE OPTION MARKET PARADIGM
Ot her st ochast i c pri ce move me nt model s have been descr i bed
by ot hers [2]. Li ke Bl ack- Schol es, t hey suppor t t he pri ci ng of
opt i ons of any mat uri t y. However, for assets subj ect to sudden or
ext r eme pri ce movement s , or whi ch are hi ghl y illiquid, a realistic
st ochast i c pri ce move me nt model may not exist. (Indeed, s ome
anal yst s (e.g., Pet ers [6]) argue that all such model s are f l awed
si nce t hey rel y on t oo many assumpt i ons that mar ket exper i ence
has shown to be unrealistic. ) Thi s does not mean that opt i ons
cannot be pr i ced for such assets, but we need a di fferent model . 7
To pri ce a call opt i on exerci sabl e at t i me t, we need an esti-
mat e of t he probabi l i t y di st ri but i on of t he under l yi ng asset pr i ce
at t i me t as vi ewed f r om t he vant age poi nt of today. I f it is pos-
sible to est i mat e this pri ce di st ri but i on, it is possi bl e to pri ce
an opt i on. Pri ci ng opt i ons of di fferent mat uri t i es consi st ent l y is
mor e di ffi cul t wi t hout a pri ce move me nt model , because it re-
qui res separat e est i mat es of t he pri ce di st ri but i on for each exer-
ci se date; but it can be done.
For mul a 1.3, wi t hout t he r equi r ement that x be l ognor mal , can
be used to pri ce any opt i on in this way. Of course, i f t he asset
pri ce at t i me t is not l ognor mal , t he call opt i on pur e pr e mi um
deri ved usi ng For mul a 1.3 is not equi val ent to Bl ack- Schol es.
As wi t h t he est i mat i on of loss di st ri but i ons, det er mi nat i on of t he
pri ce di st ri but i on of an asset may be made di ffi cul t by sparseness
of data.
5. COMBI NI NG THE OPTI ON AND ACTUARI AL PARADI GMS
Sect i on 1 est abl i shed that opt i on pri ci ng is anal ogous to ex-
cess of loss i nsur ance pricing. Sect i on 3 showed how new in-
surance i nnovat i ons can be devel oped usi ng t he opt i on mar ket
pr oduct par adi gm. Sect i on 4 di scussed how to pri ce opt i ons out-
7Even for the pricing of options on equities, for which Black-Scholes is widely used,
traders recognize its imperfections. Fischer Black even wrote a paper entitled "How to
Use the Holes in Black-Scholes," reprinted in [3]!
APPLICATION OF THE OPTION MARKET PARADIGM 717
si de t he Bl ack- Schol es f r amewor k. Thi s sect i on will i l l ust rat e
how t he synt hesi s of t hese ideas can lead to new pr oduct concept s
out si de t he current scope of anyt hi ng wi del y offered in ei t her t he
fi nanci al or i nsur ance mar ket today.
Opt i ons on Rei nsurance Premi ums
Consi der t he fol l owi ng. A rei nsurance cont ract can be t hought
of as an asset, namel y t he ri ght to recover t he monet ar y val ue of
qual i fyi ng i nsurance cl ai ms f r om a reinsurer.
The pri ce of a rei nsurance cont ract is nor mal l y negot i at ed in
t he t wo or t hree mont hs pri or to t he i ncept i on or anni versary of
t he contract. Somet i mes t here is si gni fi cant uncert ai nt y about t he
final pri ce until t he compl et i on of t he negot i at i ons bet ween t he
cedi ng company and reinsurers. Under certain ci rcumst ances, it
mi ght be val uabl e to a cedi ng company to fix t he cost of its
r ei nsur ance cover age at an earlier date, or at least est abl i sh an
upper bound. Usi ng t he opt i on pr i ci ng par adi gm, it is possi bl e
to est abl i sh a way to pri ce such a cap.
Si nce t he r ei nsur ance pr emi um, prem t, for cover age i ncept i ng
at t i me t > 0 ( wher e t i me 0 woul d be t oday) is not known wi t h
cert ai nt y today, it is a r andom variable. The pur e pr e mi um of a
call opt i on on prem t can t herefore be cal cul at ed usi ng For mul a
1.3! Let us use an exampl e to illustrate this.
Suppos e t he rate on line (i.e., t he pr emi um di vi ded by t he
limit) of a cat ast rophe rei nsurance cont ract current l y in force is
20%. It is six mont hs i nt o t he year and t here has been a total
loss to t he layer. Ther e was also a total loss t hree years ago.
In light of this experi ence, t he pr e mi um for renewal will prob-
ably be i ncreased, refl ect i ng an upwar d r eassessment by rein-
surers of t he exposur e to loss. The cedi ng company will al so
probabl y be wi l l i ng to pay a somewhat i ncreased rate to begi n to
"pay back" reinsurers. However, t he new rate will not be estab-
l i shed until cl oser to t he renewal date. In t he meant i me, for t he
7 ! 8 APPLI CATI ON OF THE OPTI ON MARKET PARADI GM
next several months the premium the cedant faces for renewal is
unknown and uncertain.
Suppose the market rate on line for renewal, viewed from
the point six months prior to renewal, has a mean of 30% and
is lognormally distributed with parameters (-1. 20, . 125). This
implies that a rate increase of some size is nearly certain. It also
implies about a 10% chance of a price of 35% or greater and
about a 1% chance of a renewal price over 40%.
Formula 1.3 can be used to determine the pure premium of a
call option to buy the reinsurance at renewal at a 30% rate on line
(or any other price). If r = 5% and t = .5 (= 6 months), Formula
1.3 implies an option pure premium of (.975)(1.5%)= 1.46%
rate on line, or 4.9% of the strike price of 30% rate on line.
If the ceding company were to buy this call option, it would
be certain that the total cost of renewal would be no more than
31.46% rate on line (30% + 1.46%), and it might be less, since if
the reinsurance market quotes less than 30%, the cedant would
let the option expire unexercised.
Is this reinsurance premium call option a financial derivative
or a reinsurance premium? The answer is, it could be either. In
the way it was described above, it has the form of a derivatives
market instrument. But the concept can also easily be incorpo-
rated into a reinsurance contract. Let us assume the renewal date
is January 1. The option to buy the 12 months coverage incept-
ing next January 1 can be embedded in a reinsurance contract
with a premium payment warranty. If a certain required premium
payment is not received before inception, the contract does not
come into force.
In periods of significant reinsurance pricing uncertainty, pur-
chasing a premium option will reduce that uncertainty and fa-
cilitate a ceding company' s reinsurance planning and budgeting
process. The specialist reinsurance market for this type of cov-
erage historically has been largely found in London.
APPLICATION OF THE OPTION MARKET PARADIGM 719
Rate Guarantees
The option paradigm can also be used to think properly about
multi-year rate guarantees in the primary insurance market. In-
sureds sometimes seek to negotiate a fixed rate for several years
or a limit on future rate increases. In these cases the insured is
seeking, in effect, to secure a call option, or series of options, on
future rate levels.
Suppose the insured wants a three-year rate guarantee for cov-
erage that would normally be subject to an annual rate review.
The current rate (which is guaranteed) is denoted by R o. The
market rates for coverage renewing one year and two years from
now, respectively, are random variables R l and R 2. If the dis-
tributions of R 1 and R 2 can be estimated, it is possible to price
the call options the insured is seeking. Then the insured can be
charged for the options. Alternatively, the insurer may decide
not to charge for the options, and merely use the options pricing
exercise to determine the effective rate decrease the three-year
guarantee represents.
If the options cannot be priced because the distributions of R 1
and R 2 cannot be estimated with sufficient confidence, perhaps
it would be unwise for the insurer to agree to the rate guarantee!
At the time this paper was being prepared, multi-year con-
tracts were beginning to appear in the reinsurance market as
well. Obviously the same thought process applies to both in-
surance and reinsurance.
6. CONCLUSION
This paper has sought to demonstrate the value of the options
market paradigm in thinking about and developing new insur-
ance solutions. As the relationship between Formulas 1.1 and
1.3 makes clear, the underlying mathematics of insurance and
the broader financial markets is the same. Apart from potential
regulatory constraints, there is no logical reason why we should
720 APPLI CATI ON OF THE OPTI ON MARKET PARADI GM
not see a conver gence of i nsurance and ot her fi nanci al servi ces in
t he comi ng years. Thi s is especi al l y likely at t he whol esal e level
(e.g., rei nsurance), wher e t he relative i mpor t ance of di st ri but i on
syst ems and cust omer i nt erface recedes and t he i mpor t ance of
pur e risk charact eri st i cs increases.
APPLICATION OF THE OPTION MARKET PARADIGM 721
REFERENCES
[1] Black, Fischer and Myron Scholes, "The Pricing of Options
and Corporate Liabilities," Journal of Political Economy 81,
May-June 1973, p. 637.
[2] Gerber, Hans and Elias Shiu, "Martingale Approach to Pric-
ing Perpetual American Options," ASTIN Bulletin 24, 2,
November 1994, p. 195.
[3] Konishi, Atsuo and Ravi Dattatreya, The Handbook of
Derivative Instruments, Chicago, Probus Publishing Co.,
1991.
[4] Hogg, Robert V. and Stuart A. Klugman, Loss Distributions,
New York, John Wiley & Sons, 1984.
[5] Redhead, Keith, Introduction to Financial Futures and Op-
tions, Cambridge, England, Woodhead-Faulkener Limited,
1990, pp. 98-102, 161-162.
[6] Peters, Edgar, Fractal Market Analysis, New York, John Wi-
ley & Sons, 1994.
[7] Hull, John, Options, Futures, and Other Derivatives, Third
(International) Edition, London, Prentice Hall International,
Inc., 1997.
[8] Kemp, M. H. D., "Actuaries and Derivatives," British Actu-
arial Journal 3, Part I, 1997, p. 51.
722 APPLICATION OF THE OPTION MARKET PARADIGM
APPENDIX A
DERIVATION OF THE BLACK- SCHOLES OPTION PRICING
FORMULA FROM A LOGNORMAL ASSET PRICE ASSUMPTION
Le t
eo=
l =
F=
t h e c u r r e n t ma r k e t p r i c e o f t h e s e c u r i t y u n d e r l y i n g
t h e o p t i o n ,
t i me ( i n ye a r s ) t o o p t i o n e xpi r y,
t h e r i s k - f r e e i nt e r e s t r at e u s e d f o r c o n t i n u o u s
c o m p o u n d i n g (i . e. , t he f o r c e o f i nt e r e s t ) ,
x -- a r a n d o m va r i a bl e f o r t he f u t u r e ma r k e t p r i c e o f t h e
s e c u r i t y u n d e r l y i n g t he o p t i o n , at t i me t ( e xpi r y) .
A s s u m e x is l o g n o r ma l l y d i s t r i b u t e d wi t h p a r a me t e r s l n P 0 + r t -
0. 5~2t a n d a v e , a n d me a n E ( x ) = Pt = e xp( l nP0 + r t ) . Th i s i m-
pl i e s Pt = P0' eft.
X t = t h e a c t ua l f u t u r e ma r k e t p r i c e o f t he s e c u r i t y
u n d e r l y i n g t he o p t i o n , at expi r y.
c t ( S ) = t he c u r r e n t p u r e p r e mi u m (i . e. , i g n o r i n g t r a n s a c t i o n
c o s t s a n d r i s k) f o r an o p t i o n t o b u y t he u n d e r l y i n g
s e c u r i t y at a p r i c e o f S at t i me t. Th i s i s k n o wn as a
" cal l o p t i o n wi t h a s t r i ke pr i c e o f S. " Be c a u s e o f i t s
f e a t u r e o f e x e r c i s e at o n l y o n e da t e , it i s k n o w n as a
E u r o p e a n o p t i o n .
T h e cal l o p t i o n c t ( S ) wi l l h a v e n o i nt r i ns i c v a l u e at e x p i r y i f
t he ma r k e t pr i c e , X t, o f t he s e c ur i t y is b e l o w t he s t r i ke pr i c e , S. I n
t ha t cas e, it i s c h e a p e r t o b u y t h e s e c ur i t y di r e c t l y at p r i c e X t t h a n
t o e x e r c i s e t o o p t i o n t o b u y at e x p i r y p r i c e S. No r a t i ona l i n v e s t o r
wo u l d p a y a n o n - z e r o p r e mi u m f o r s u c h an o p t i o n ; h e n c e i t s ni l
va l ue .
c t ( S ) wi l l h a v e i nt r i ns i c va l ue o f X t - S at e x p i r y i f t he ma r k e t
p r i c e X~ e x c e e d s t he s t r i ke p r i c e S. An i n v e s t o r wo u l d be i ndi f -
f e r e n t t o b u y i n g t he s e c u r i t y di r e c t l y at pr i c e X t a nd b u y i n g t he
APPLICATION OF THE OPTION MARKET PARADIGM 723
call opt i on c t ( S ) at a pri ce of X t - S for i mmedi at e exerci se at
pri ce S.
The pur e pr e mi um of c t ( S ) is t he probabi l i t y wei ght ed mean
of all possi bl e intrinsic val ues at expiry, di scount ed to refl ect
pr esent value. 8
If t he correct interest rate for di scount i ng is t he ri sk-free rate,
t he pur e pr e mi um is expressed as:
= e - r t . ~S( x -- S ) . f ( x ) d x (A. 1)
t ( S)
( i s )
= e - r t " x " f ( x ) d x - S ( x ) d x (A. 2)
( / : s
= e - f t . x . f ( x ) d x - x . f ( x ) d x
In general , t he first mome nt di st ri but i on
~
A X" f ( x )
d x
E(x)
of a l ognor mal variate x wi t h paramet ers (#, a) is also l ognor mal
wi t h par amet er s (# + 0 - 2 , o ' ) .
In t he pr esent case, x is l ognor mal ( l nP 0 + r t - O. 5 0 . E t , 0 . x / t )
and its first mome nt di st ri but i on has par amet er s (ln P 0 + r t +
0.50.2t,0.x/t). Accordi ngl y, t he second t erm wi t hi n t he mai n
SThe justification for use of the risk-free rate is described in footnote 2 in the body of
the paper.
724 APPLI CATI ON OF THE OPTI ON MARKET PARADI GM
br acket s o f For mul a A. 3 can be r est at ed as f ol l ows:
f o S x " f ( x ) d x = E ( x ) ' N ( l n S - ( I n P + r t + O'5cr2t) ) c r y / ~
= p t . N ( l n S - ( l n P o + r t + O .5 ~ 2 t))
a v q
whe r e N is t he cumul at i ve di st ri but i on f unct i on of t he st andar d
nor mal di st ri but i on.
Eval uat i on o f t he ot her t er ms o f For mul a A. 3 is st rai ght for-
war d, and this f or mul a can now be rewri t t en as:
- S e - r t ' ( 1 - N ( ln s-(ln P + rt-O '5 a 2 t))~ rv~ )
=P(1-N(lnS-lnP-(r+O'5cr2)t))~--v~
-Se-rt'(1-N(lnS-lnP-(r-O'5cr2)t))~v/7
=Po(1-N(ln(S/P)--(r+O'5cr2)t))\ cry/~
7 , ~ J / ;
( A. 4)
and, si nce 1 - N ( z ) = N(- z),
c t ( S ) = P " N ( ln ( P /S ) + ( r + O'5cr2)t ) C r y ' 7
_ S e - r t . N ( l n ( e o / S ) + ( r - O.5cr2) t )
7~$7- . (A.5)
APPLICATION OF THE OPTION MARKET PARADIGM 725
Let
and
d i = l n ( P o / S ) + ( r + 0.5cr2)t
~vq '
d 2 = l n ( P o / S ) + ( r - 0.5a2)t
Then Formula A.5 can be restated as
c t ( S ) = Po " N ( d l ) - S e - r t " N(d2)"
This is the Bl ack-Schol es option pricing formula.
(A.6)
726 APPLICATION OF THE OPTION MARKET PARADIGM
APPENDI X B
VALUATION OF CALL, PUT, AND CYLINDER SPREADS
C a l l S p r e a d s
T h e v a l u e o f a c a l l s p r e a d c t ( T j ,T2) wi t h T 2 > T l a n d t i me t t o
e x p i r y is g i v e n b y
c t ( T l ,T2) = c t ( T ~ ) - c t ( T 2 )
= e - r t
= e - r t
( x - T I ) . f ( x ) d x - . ( x - T2). f ( x ) d x
[ f ~ ; Z ( x - T , ) ' f ( x ) d x + f T T ( X - T l ) ' f ( x ) d x
- 7 ( x - T 2 )- f ( x ) d x I
No t e t h e s i mi l a r i t y t o t he f o r mu l a s u s e d t o wo r k wi t h e x c e s s
l a ye r s i n i n s u r a n c e a p p l i c a t i o n s .
I f t he a c t ua l p r i c e o f t he u n d e r l y i n g as s et at e x p i r y o f t he
o p t i o n is X t, t he v a l u e o f t he l o n g cal l s p r e a d p o s i t i o n at e x p i r y
i s g i v e n by
T2- T1, X, _> T2;
X, - T I , T 2 > X , > 5 ;
O, ~ > _ x ,.
Th i s is s h o wn g r a p h i c a l l y i n F i g u r e B- 1.
= e - r t ( x - T 1 ) - f ( x ) d x + ( T 2 - T 1 ) . f ( x ) d x .
( B. 1)
APPLICATION OF THE OPTION MARKET PARADIGM 727
FI GURE B- 1
EXPIRY VALUE PROFILE: CALL OPTION SPREAD ct(T1,T2)
Expi r y
Val ue
T,.-T~
I I
T , T 2
Under l yi ng Asset Pri ce at Expi r y, X t
P u t S p r e a d s
The val ue o f a p u t s p r e a d P t ( S 1 , S 2 ) wi t h S 1 > S 2 and t i me t t o
expi r y is gi ven by
P t ( S I , $2) = P t ( S 1 ) - P t ( S 2 )
[/o s /o"
= e - r t (S 1 - x ) . f ( x ) d x - (S 2 - x ) . f ( x ) d x
[/o" Z ? ~s,
= e - r t (S 1 - x ) " f ( x ) d x + - x ) . f ( x ) d x
- f o s ~ ( S 2
- x ) f ( x ) d x ]
e /o" ]
= - x ) . f ( x ) d x + (S 1 - $2). f ( x ) d x .
(B. 2)
728 APPLICATION OF THE OPTION MARKET PARADIGM
F I G U R E B-2
EXPIRY VALUE PROFILE: PUT OPTI ON SPREAD Pt(Si,S2)
Expi ry
Val ue
S,-S=
I I
$2 ST
Underl yi ng Asset Price at Expi ry, X,
T h e v a l u e o f t h e l o n g p u t s p r e a d p o s i t i o n at e x p i r y i s g i v e n b y
O, x , > s1;
S 1 - xt, S 1 >x t 2>32;
S 1 - 82, S 2 ~_~X t.
Th i s is s h o wn g r a p h i c a l l y i n F i g u r e B- 2.
P u t - C a l l P a r i t y
Th e r e is an i mp o r t a n t r e l a t i o n s h i p b e t we e n t he v a l u e o f cal l s
a n d p u t s k n o w n as " p u t - c a l l pa r i t y. " Co n s i d e r t wo p o r t f o l i o s . T h e
f i r st c o n s i s t s o f an a s s e t wi t h a v a l u e o f P0 a n d a r e l a t e d p u t o p t i o n
wo r t h p t ( T l ) . T h e s e c o n d c o n s i s t s o f a T- bi l l v a l u e d at T 1 e - r t a n d
a cal l o p t i o n o n t h e a s s e t i n t he f i r st p o r t f o l i o , v a l u e d at ct ( T 1).
APPLI CATI ON OF THE OPTI ON MARKET PARADI GM 729
These t wo port fol i os have i dent i cal expi ry value profi l es (namel y,
max(T1,Pt)), so unl ess t here are obst acl es to arbi t rage t radi ng,
t hey must have equal mar ket val ues for any T 1 _> 0:
Po + p t ( TI ) = T1 e - r t + ct(T1). (B.3)
We can use put-call pari t y to deri ve t he anal ogous rel at i onshi p
bet ween put and call spreads:
Si nce
T1 e - n = Po + Pt ( TI ) - G( TI )
and
T2 e - r t = eo + pt ( T2) -- ct(T2),
t hen
( T 2 - T l ) e - r t = p t ( T 2 ) - c t ( T 2 ) - p t ( T l ) + c t ( T 1 )
= c t ( ~ , T : ) + p t ( T z , T ~ ) . (B.3a)
A br i ef analysis of For mul a B. 3a shows that it is consi st ent wi t h
usi ng t he ri sk-free rate for di scount i ng Eur opean opt i on pur e
pr emi ums. I f we restate For mul a B. 3a in t erms of integrals and
treat t he interest rate to be used for di scount i ng t he ri ght si de of
t he equat i on as an unknown, i, we obtain:
(T 2 - T l ) e - r '
= e - i t ( f T T 2 ( x - - T 1 ) ' f ( x ) d x
/ ( / o r '
+ ( T 2 - T 1 ) . f ( x ) d x + ( T 2 - x) " f ( x ) d x
730 APPLICATION OF THE OPTION MARKET PARADIGM
TABLE 3
Expiry Long Call Short Put Cash Short Put +
Price Value Value Value Cash Valim
X , >_ T 2 T2 - T t 0 T2 - T , T2 - T ,
T2 > X, > T , X, - T, - ( T2 - X , ) T2 - T , Xt - T,
T, > X, o - ( r 2 - T , ) T 2 - T , o
= e - i t ( f o T 2 ( x - T l ) f ( x ) d x .
J ? )
+ ( T 2 - T 1) - f ( x ) d x + ( T 2 - x ) " f ( x ) d x
= e - i t ( f o T 2 ( T 2 - T l ) ' f ( x ) d x + / : 7 ( T 2 - T l ) f ( x ) d x ) ,
= e- i ' (T 2 - T 11- f ( x ) d x
, 0
= e - i t ( T 2 _ T 1 ) ,
whi ch i mpl i es i = r.
For mul a B. 3a al so i mpl i es a defi ni t i on f or a call spr ead in
t er ms o f a put spr ead and T-bills: 9
Ct(TI,T2) = ( T 2 - T I ) e - r z - p t ( T z , T l ) . ( B. 3b)
Thi s means that it is pos s i bl e to achi eve a synt het i c call spr ead
posi t i on usi ng put spr eads and vi ce versa. In part i cul ar, For mul a
B. 3b says t hat sel l i ng a put spr ead, p t ( T z , T i ) , and hol di ng t he
pr esent val ue of T 2 - T t in T-bills is equi val ent t o buyi ng a call
spr ead, q ( T l , T 2 ) . To see this, Tabl e 3 compar es t he expi r y val ues
of t hese t wo posi t i ons.
9Note that formulas B.3a and B.3b imply a put-call parity relationship for spreads that,
unlike the ordinary put-call parity formula, has no reference to P0
APPLICATION OF THE OPTION MARKET PARADIGM 731
TABLE 4
Expiry Long Put Short Call Cash Short Call+
Price Value Value Value Cash Value
x,>r~ o - ( r ~- r , ) T~-r, 0
r2 > x, > r, r2 - x , - <x , - r 0 r 2 - r , T2 - X,
TI > X ` Tt - T ~ 0 T 2 - T I r 2 - r ,
Al t ernat i vel y, si nce
Pt ( T2, T1) = ( T 2 - Tl ) e - r ` _ c , ( T I , T 2 ) ,
buyi ng a put spread pt ( T2, T l ) is equi val ent to selling a call spr ead
c t ( T1, T2) and hol di ng t he pr esent val ue of T 2 - T l in T-bills, as
s hown in Tabl e 4.
C y l i n d e r S p r e a d s
The b u l l c y l i n d e r s p r e a d , c y l t ( S I , S z ; T I , T 2 ) , cr eat ed f r om t he
call and put spr eads def i ned above, wher e T 2 > T l > Sl > $2, has
t he f ol l owi ng value:
cyl(S1 , S2; TI , T2) = c t ( T 1 , T2) - p t ( S l ,$2)
= e - r t ( x -- T 1) . f ( x ) d x + ( T 2 - T 1 ) . f ( x ) d x
_ t' j S, ( S I _ x ) . f ( x ) d x
J S 2
- - f 0 S 2 ( s 1 - S 2 ) . f ( x ) d x ] . ( B. 4 )
The val ue of cylt(S1,Sa;T1,T2) depends on t he choi ces o f S l, S 2,
T 1 and T 2. Thes e par amet er s can be chosen to creat e a cyl i nder
st ruct ure t hat pr oduces t he desi r ed cyl i nder val ue at t i me t to
7 3 2 APPLICATION OF THE OPTION MARKET PARADIGM
FI GURE B-3
EXPIRY VALUE PROFILE: BULL CYLINDER OPTION SPREAD
cylt ($1 ,$2, TI ,T2)
Expi ry
Val ue
Tz - T 1
- ( S , - S 2 )
/
/
I I I I
$2 $1 TI T2
Underlying Asset Price at Expiry, X,
expiry. Addi t i onal flexibility can be i nt roduced in the cyl i nder
structure by relaxing the requi rement that the same number of
call and put spreads are used. If Q is defined as the ratio of
the number of puts to the number of calls, then the value of
c y l t ( S 1 , S 2 ; T 1 , T 2) is given by
cyl(S l , $2; T], T2)
= e - r t [ / T ( 2 ( x - T 1 ) " f ( x ) d x + [ ( T 2 - T l ) " z
- Q. - x) . f ( x) dx
/ : 2
+ (S 1 - $2). f ( x ) d x .
APPLICATION OF THE OPTION MARKET PARADIGM 7 3 3
At expiry the value of the bull cylinder spread position is given
by
~ - ~ , x t ___ ~ ;
x t - ~, vz > x , ___ T~;
O, I"1 > x , > s ~ ;
- Q . ( S 1 - x t ) , S 1 ~ St ~" S 2 ;
- Q . (S 1 - S 2 ) , $2 ~> X t.
This is illustrated for Q = 1 in Figure B-3.