Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 11

Managing Vanilla Options Risk

Every book should have a hero. The hero of this book is not a person but an equation: the Black-Scholes formula for pricing European-style options. Like every hero, it has its flaws and no shortage of detractors ready to point them out. But with help from some friends, it can recover to play a vital role in integrating all options risk into a unified, manageable framework. This is the theme of this chapter and the next.

Options risk may be subdivided into two categories: the risk of relatively liquid options, termed plain-vanilla or vanilla options, and the risk of less liquid options, termed exotic options. Managing options risk for vanilla options is quite different from managing options risk for exotic options, so we will discuss them in two separate chapters.

Almost without exception, the only relatively liquid options are European-style calls or puts, involving a single exercise date and a simple payoff function equal to the difference between the final price level of an asset and the strike price. As such, vanilla options can be priced using either the Black-Scholes formula or one of its simple variants (see Hull 2012, Section 14.8, Chapter 16, and Sections 17.8 and 25.13). The only notable exception to the rule that all vanilla options are European style is that some American-style options on futures are exchange traded and liquid. However, the early exercise value of such options—the difference between their value and that of the ...