Tackle Option Pricing with SAP NetWeaver BI

  • by Daniel Wood, Lecturer, Arizona State University
  • Lipika Sur, Business System Analyst
  • June 15, 2008
Perform derivative analysis using the Black-Scholes model in the SAP NetWeaver Business Intelligence system to address security concerns.

Jérôme Kerviel is a 31-year-old former futures trader for Société Générale SA, which is one of France’s principal financial services companies and its second largest bank after BNP Paribas. You may already know that Kerviel stands accused of making unauthorized futures trades under the auspices of his employer, resulting in losses totaling €4.9 billion, or $7.16 billion. Another interesting thing you may be less likely to know is that he is described by the Wall Street Journal as “a low-level trader … earning €100,000 ($145,000) a year.”

This illuminates the risks undertaken by the many wealthy institutions that deal in sophisticated derivatives contracts as a means of hedging against risk. The losses lay bare the exposure that financial markets have assumed through the adoption of derivatives, while punctuating the widely underappreciated subtext: as deeply woven as derivatives are into the tapestry of financial markets, far too few hold a working understanding of what they are and how they work.

The Kerviel scandal is a particularly salacious signal to decision-makers indicating that they should take a closer look at derivatives, but it isn’t the only signal worth considering. Kerviel dealt in one of two classes of derivatives: equity derivatives. The other class — credit derivatives — has been making its own press by way of its role in the heart of the broader global credit crisis. Non-financial media has become rife with talk of mortgage-backed securities (MBS), collateralized mortgage obligations (CMO), and collateralized debt obligations (CDO). Banks’ risky bets in financial devices based on credit derivatives have resulted in $200 billion in write-downs in the first five months of 2008.

As the details unfold, we have every reason to expect government and private action to increase regulation while promoting research and development into better risk control systems. We observed with the implementation of Sarbanes-Oxley that enterprise application products such as SAP Supply Chain Manage- ment (SCM) and SAP Customer Relationship Management (CRM) provided a convenient means by which organizations have been able to certify compliance with risk-control regulation. Enterprise products may serve a similar role with the inevitable regulation spurned by turbulent derivatives markets.

Pricing options is important to many parties. Many companies retain stock options as a tool in their employee compensation arsenal. Some companies that have abandoned options have simply moved to a cousin tool that is governed by similar pricing models: restricted stock units (RSUs). The accurate valuation of options by these companies and proper reporting of that value on public financial statements has become a concern of investors, the SEC, and FASB. Therefore, beyond the obvious organizations such as investment banks and financial services companies that prepare, broker, and manage options contracts, both companies that use stock options as a compensation tool and auditing firms that sign off on their financial statements will take an interest in the models used to price them.

We’ll open the book on derivatives analysis through examination of one tool used to price stock options: the Black-Scholes model. We will look at the formula for Black-Scholes, unpack its inputs and their meaning, consider applications of the equation, and illustrate a simple model and example using SAP NetWeaver Business Intelligence (SAP NetWeaver BI).

Daniel Wood

Daniel Wood is a lecturer at Arizona State University in the W.P. Carey School of Business and a former industry SAP SCM business system analyst. He is author of SAP SCM: Applications and Modeling for Supply Chain Management (Wiley)

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Lipika Sur

Lipika Sur holds a masters’ degree in math from IIT, India and has worked for 11 years with SAP enterprise and BI products including implementations for IBM, Lucent, Hyundai, and Atmel with PwC and implementations with HP. She is currently a business system analyst at a Fortune 100 manufacturer.

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