Journal of
Financial Education

The Dangers of Calibration and Hedging the Greeks in Option Pricing

This paper shows the dangers of calibration and hedging the greeks in option pricing theory. We focus on two problems that aren’t adequately addressed in existing textbooks. First, the inappropriate use of vega hedging and, second, the errors that a misspecified but calibrated model introduces into delta hedging. A simple example illustrates our insights in a transparent manner.

The use of financial trading labs within university settings is in a growth phase, with more colleges and universities finding the need to build one just to stay competitive. This paper gives information on the various steps in the development process of the trading lab, key factors for building a lab, and key questions that need to be addressed while in the formulation phase of the lab design. In addition various hardware designs, fund raising opportunities, utilization methods are discussed.

The literature demanding more ethics-based decision making in the business environment greatly outweighs the actual amount of literature in which specific business decisions are evaluated based on their ethical efficacy. This paper helps to remedy this gap by introducing four ethical models and their relevance to bankruptcy proceedings in a case study context. It objectively introduces students to multiple ethical models while directly applying those models to a specific situation. Thus, the students’ ethical imagination ability will be greatly increased, regardless of what their particular pre-conceived beliefs about business ethics are. The case study also has students assess the impact of their pre-conceived beliefs on their decision-making processes. Neither the introduction to ethical models nor the case study is prescriptive; it is up to the students to make their own ethical evaluations.

Linear programming models and their extensions have enjoyed a long history with portfolio optimization problems. Maximization of expected returns is typically sought under a set of restrictions. After an optimal portfolio is identified, sensitivity analysis of the objective function coefficients (the expected returns) might be of interest. This presents a problem however, since sensitivity analysis traditionally must be done for a single coefficient at a time. There has not heretofore been known a method that permits this sensitivity analysis when several coefficients (returns) vary simultaneously. A new procedure is presented here that carries out the range of optimality sensitivity analysis for the optimal portfolio when expected returns are subject to synchronized and simultaneous fluctuations.

This note, with a numerical example, demonstrates that evaluating a replacement project is equivalent to assessing two mutually exclusive projects. This unconventional view requires no more knowledge on the part of students than what is required to evaluate a single expansion project. Textbooks typically use separate sections of a chapter to explain how to evaluate expansion projects and replacement projects, leading students to think that there are two entirely different methodologies. We show that there is really only one methodology. Conceptually, our proposed approach is much easier for students to understand. Moreover, this alternative view uncovers a potential pitfall associated with the NPV when the two assets involved in the replacement project do not have the same remaining useful life. This note further revises the MIRR and modifies the PI to reconcile possible ranking conflicts between the two rules and the NPV when dealing with mutually exclusive projects.

Suppose a company enters into an interest rate swap as the fixed-rate payer, and the swap agreement is terminated prior to maturity. If interest rates have fallen in the interim, the firm will be required to pay a swap termination fee. The fee (over a quarter of a million dollars in this case) should be easily calculated as the present value of the difference in two sets of interest payments. The first would be based on the fixed rate on the swap; the second would be based on market rates for similar swaps on the termination date. Yet calculation of the appropriate fee became the subject of litigation; the alleged error may be as much as $100,000 on a $2 million dollar swap. The case also raises the ethical question as to whether it is appropriate banking practice to advise a small firm to enter into a nine-year swap and then force termination in two years. The case is designed for courses in both derivatives and bank management.