Timer Call
Encyclopedia
The Timer Call is an Exotic option
, that allows buyers to specify the level of volatility used to price the instrument.
As with many leading ideas, the principle of the timer call is remarkably simple: instead of a dealer needing to use an implied volatility
to use in pricing the option
, the volatility is fixed, and the maturity is left floating. As a result of this, the Timer Call allows the pricing of call and put option
s on underlyings for which ordinary options are not priced; dealers in a normal option are exposed to the difference between the volatility they estimate and the realised volatility, whereas in a Timer Call, this risk is much diminished.
In 2007, Société Générale
Corporate and Investment Banking
(SG CIB) started to market this idea, apparently oblivious of Bick's earlier work in the area. Indisputably, SG CIB popularised it.
Since then, most dealers have put in place the technology to offer this sort of option. Assuming the interest rate is zero, Carr and Lee (2010) investigated the pricing and hedging of options on continuous semi-martingales. Li (2008) gave an explicit formula for pricing timer options under the Heston (1993) stochastic volatility model. His result is a natural generalization of Black-Scholes-Merton formula for pricing European options and reconciles with the zero interest rate case in Carr and Lee (2010). Li (2008) provides some insight of using the Bessel process with constant drift, which was studied in Linetsky (2004), with drift to characterize the distribution of the so called volatility clock under the celebrated Heston (1993) stochastic volatility model.
Exotic option
In finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter , or are embedded in structured notes....
, that allows buyers to specify the level of volatility used to price the instrument.
As with many leading ideas, the principle of the timer call is remarkably simple: instead of a dealer needing to use an implied volatility
Implied volatility
In financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...
to use in pricing the option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, the volatility is fixed, and the maturity is left floating. As a result of this, the Timer Call allows the pricing of call and put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
s on underlyings for which ordinary options are not priced; dealers in a normal option are exposed to the difference between the volatility they estimate and the realised volatility, whereas in a Timer Call, this risk is much diminished.
History
It appears that the idea was first published in the literature in April 1995 in Management Science by Avi Bick. This paper contained the same idea (including the derivation of the relevant formula) that has since been popularised.In 2007, Société Générale
Société Générale
Société Générale S.A. is a large European Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Société Générale in the business district of La...
Corporate and Investment Banking
Investment banking
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...
(SG CIB) started to market this idea, apparently oblivious of Bick's earlier work in the area. Indisputably, SG CIB popularised it.
Since then, most dealers have put in place the technology to offer this sort of option. Assuming the interest rate is zero, Carr and Lee (2010) investigated the pricing and hedging of options on continuous semi-martingales. Li (2008) gave an explicit formula for pricing timer options under the Heston (1993) stochastic volatility model. His result is a natural generalization of Black-Scholes-Merton formula for pricing European options and reconciles with the zero interest rate case in Carr and Lee (2010). Li (2008) provides some insight of using the Bessel process with constant drift, which was studied in Linetsky (2004), with drift to characterize the distribution of the so called volatility clock under the celebrated Heston (1993) stochastic volatility model.
Benefits
- Suppression of implied volatility’s extra cost in call options: Call prices depend on the implied volatility level, usually higher than realised volatility, representing the risk premiumRisk premiumA risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
, seen as an extra cost of call prices. The Timer Call avoids this extra cost. - Systematic market timing: The Timer Call systematically optimizes market timingMarket timingMarket timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
. If volatility increases, the call terminates earlier, with the investor realising a profit. If the vol doesn’t rise, the call simply takes more time to reach maturity. In other words, time becomes extractable as an investible asset classAsset allocationAsset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
(like volatility became an asset class with the invention of the vol swap).