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com/abstract=2043503
Robust Calculation of MFIV from Calibrated
Surfaces
Philip Stahl
∗
and Philipp B. Rindler
†
Working Paper — Feb 2012
Abstract
This paper proposes a new method to calculate modelfree implied
volatility from a calibrated option price surface. This circumvents com
mon interpolation/extrapolation problems found in established method
ologies, where prices enter calculation directly, and is numerically more
stable. Areas outside the observable strikes are approximated better. Pre
dictive regressions over 180 months based on this new method show that
the new method is indeed superior in most cases, even with only very few
observable strikes.
Keywords: Option pricing, modelfree implied volatility, characteristic
functions
JELClassiﬁcation: C61 C80 G13
1 Introduction
For ﬁnancial institutions and investors, reliable ways of forecasting risk of in
vestments is of utmost importance. Mostly reduced to the variation of returns,
∗
mail@philipstahl.com
†
philipp.rindler@ebs.edu
1
Electronic copy available at: http://ssrn.com/abstract=2043503
active option trading allows to extract the views about return variation of the
average investor from option prices. Implied variance depends on the dynamics
of the underlying model, and are usually only computed for atthemoney op
tions. BrittenJones and Neuberger (2000) extended prior work by showing that,
for stochastic volatility diﬀusions, an inﬁnite number of price processes can be
consistently ﬁtted to observed option prices, thus deriving a modelfree implied
variance (MFIV). This requires not only atthemoney option prices, but uses
the whole continuum of strikes, and levers available information more eﬀective.
Jiang and Tian (2005) propose a procedure to deal with limited data observabil
ity by interpolation and extrapolation of BlackScholes implied volatility over
strikes. Their implementation is the established way of calculating MFIV nowa
days, such as in Bollerslev et al. (2009) and Bollerslev et al. (2010). Also, the
CBOE volatility index VIX is based on this methodology.
Drechsler and Yaron (2011) show that the variance premium can give an
idea about longrun uncertainty aversion and may be helpful in predicting stock
market returns. Carr and Wu (2009) deﬁned the variance premium as the
diﬀerence between realized variance under physical probability measure P and
the expected future realized variance under risk neutral measure Q. Under
no arbitrage, variance swaps represent the riskneutral expectation of future
realized variance. They synthesize variance swaps from options to calculate
MFIV, and do so from a crosssection of options over strikes.
However, the crosssection of option prices is often very small. Only options
trading on the same stock and the same maturity can be considered, which
are rarely enough. Most studies limit their scope to indices with many active
options or sort out stocks with too few options. Furthermore, they employ the
methodology suggested by Jiang and Tian (2005), which relies on numerically
2
unstable interpolation with cubic splines and the assumption of constant option
prices outside the observable range. This introduces additional sources of error
in the estimation of MFIV and may give a false sense of conﬁdence in the results.
In this paper we develop an indirect approach to calculate MFIV by cali
brating a prespeciﬁed model to ﬁt option prices, and calculate MFIV from
a dense grid of theoretical option prices. The speciﬁcation of the model can
be interpreted as sophisticated interpolation algorithm. Implied volatility is
still calculated from the cross section of option prices, but is less vulnerable to
option prices that behave diﬀerent than expected (e.g., mispricing, or market
microstructure anomalies that may deform the surface). In regression analysis,
the proposed method has higher explanatory power for realized variance than
the Carr and Wu (2009)implementation. The remainder of the paper is as fol
lows: Section 2 gives an overview of the theory of MFIV and explains where
errors arise. Section 3 describes the methodology by Jiang and Tian (2005) as
well as the improved one in detail. Section 4 lays out regression results and
Section 5 concludes.
2 ModelFree Implied Variance
2.1 Synthetic variance swaps
Originally, BrittenJones and Neuberger (2000) derived the MFIV only in
a diﬀusion setting. This was later extended by Jiang and Tian (2005), who
generalize the the underlying stochastic process to include jumps. Carr and Wu
(2009) show that the basic formula can be derived in a semimartingale setup.
They quantify the return variance as variance swap that pays according to
realized variance and synthesize variance swap rates from option prices. Under
risk neutrality, the variance swap rate has to equal the expectation of the future
3
realized variance such that
SW
t,T
= E
Q
t
[RV
t,T
] (2.1)
The following paragraphs redraw their derivation of future quadratic varia
tion from option prices.
Let S
t
denote the time t spot price of an asset, F
t
its time t futures price
with maturity T > t. By no arbitrage, there exists a riskneutral, ﬁltered
probability space (Ω, F, (F
t
), Q) on which the futures price F
t
is a sum of a
purely continuous martingale and a purely discontinuous (jump) martingale:
dF
t
= F
t−
σ
t−
dW
t
+
_
R
0
F
t−
(e
x
−1)[µ(dx, dt) −ν
t
(x)dxdt] (2.2)
where W
t
is a standard Brownian motion (under Q), R
0
≡ R\{0}, F
t−
is the
left limit of the futures price at time t (the futures price prior to a jump at time
t), and µ(dx, dt) is the random counting measure which is nonzero for a given
value of x if and only if the futures price jumps from F
t−
to F
t
= F
t−
e
x
at time
t. Finally, ν
t
(x) is the compensator process corresponding to µ.
1
Under the dynamics in (2.2), the quadratic variation on the futures return
from time t until maturity at T is given by:
V
t,T
=
_
T
t
σ
2
s−
ds +
_
T
t
_
R
0
x
2
µ(dx, ds) (2.3)
The annualized return variance is then given by RV
t,T
=
1
T−t
V
t,T
. The idea
of MFIV is that the quadratic variation can be replicated by a static portfolio
1
It is assumed that the jump process is of ﬁnite variation, i.e.
R
0
(x ∧ 1)ν
t
(x)dx < ∞.
Moreover, σ
t−
and ν
t
(x) are both stochastic and predictable with respect to the ﬁltration F
t
and restricted so that the futures price F
t
is always positive.
4
of options with maturity T and a dynamic position in futures. When the un
derlying process is a diﬀusion, this replication is exact. Assuming jumps in the
dynamics leads to higherorder correction terms as shown below.
Under Q, futures trading can be done at no cost, such that the riskneutral
expected value of the quadratic variation can be approximated by the value of
the options in the static replicating portfolio. Carr and Wu (2009) specify the
following
Proposition 1. Under absence of arbitrage, the riskneutral expected value of
return quadratic variation of an asset over horizon [t, T] deﬁned in (2.3) can
be approximated by the continuum of European outofthemoney option prices
across all strikes K > 0 and at the same maturity date T
E
Q
[RV
t,T
] =
2
T −t
_
∞
0
Θ
t
(K, T)
B
t
(T)K
2
dK + (2.4)
where B
t
(T) denotes the timet price of a bond paying one dollar at T,Θ
t
(K, T)
denotesthe timet value of an outofthemoney option with strike price K > 0
and maturity T ≥ t (a call option when K > F
t
and a put option when K ≤ F
t
),
and denotes the approximation error, which is zero when the futures price
process is purely continuous.
For the remainder of the paper, equation (2.4) serves as deﬁnition of MFIV.
In the next section the calculation in practice is examined in detail.
2.2 Implementation issues
From equation (2.4) it is easy to see that calculation of MFIV requires nu
merical integration over an inﬁnite domain, i.e. an inﬁnite amount of strikes
with inﬁnitesimal distance ranging from K = 0 to K = ∞. In practice, these
requirements are not fulﬁlled. Strikes are often spaced several dollars from each
5
other, most options issued are somewhat close to being atthemoney (close in
relation to zero and inﬁnity), and certainly only a ﬁnite number of options is
traded. Two sources of errors arise: Truncation and discretization.
Truncation refers to the reduction of the integration domain from [K
0
, K
∞
]
to [K
min
, K
max
], where K
min
< F
0
< K
max
, thus strikes are observable around
the forward price. Jiang and Tian (2005) derive theoretical upper bounds for
truncation errors beyond the strike range.
Discretization stems from the distance between observable strikes ∆K > 0.
The strike surface is discrete and cannot be be integrated without interpolation.
Using approximations such as rectangle rule, trapezoidal rule, or Simpson’s rule
are interpolation methods. Interpolations induce an additional source of error to
the calculation, which can be severe under complicated or uncommon observed
price structures.
3 Methodology
3.1 Current methodology
Calculation of MFIV requires a continuum of strikes and in practice inter
polation between strikes as well as extrapolation outside the observable region
is necessary. Jiang and Tian (2005) suggest to use natural cubic splines to
interpolate and to keep observed option prices constant outside [K
min
, K
max
].
According to Shimko (1993) and AitSahalia and Lo (1998), the nonlinear re
lationship of option and strike prices may induce an upward bias, and they
suggest using BlackScholes implied volatility as symmetric transformation of
option prices to apply curve ﬁtting methods that provide the required continuum
of strikes. Beyond the observable range of strikes, Jiang and Tian (2005) note
6
Figure 1: Extrapolation of strikes on a simulated implied volatility surface,
based on parameter set 1 from Jiang and Tian (2005).
that other extrapolation methods than keeping the price constant may lead to
large estimation errors and negative implied volatilities. Figure 1 depicts diﬀer
ent extrapolation methods on an implied volatility surface of observable strikes.
The observed surface is calculated from a Heston (1993)Model with Parameters
S = 100, r = 0, v
0
= 0.04, ρ = −0.5, κ = 2, θ = 0.04, λ = 0, σ
volatility
= 0.225,
which are the same as in Jiang and Tian (2005, parameter set 1). The strikes
are equally spaced with ∆K = USD5 and symmetrically distributed around S.
The diﬃculty of curveﬁtting is evident.
Jiang and Tian (2005) simulate a price surface with stochastic volatility and
jumps in the price process. From this surface, they estimate the eﬀectiveness
of their curveﬁtting method to assess its appropriateness to overcome limited
information by reducing the strikes that enter the MFIV calculation, but only
consider isolated situations where either truncation or discretization occur and
strikes are equidistant. In earlier work, we have extended this analysis and
considered random drafts from a simulated option price surface of decreasing
7
size to replicate the patterns observed in real data (Stahl (2010)). We conclude
that the method of Jiang and Tian (2005) is appropriate if the observed volatility
surface is very smooth, but may be far out if option prices exhibit deviations
from a smooth surface or very few prices are available.
Carr and Wu (2009) perform two interpolations: the ﬁrst over strikes, the
second over maturities. On the strike dimension, they follow Jiang and Tian
(2005). Over maturities, they interpolate linear between two available maturi
ties T
1
and T
2
to gain the variance between t to T by
SW
t,T
=
1
T −t
[
SW
t,T
1
(T
1
−t)(T
2
−T) + SW
t,T
2
(T
2
−t)(T −T
1
)
T
2
−T
1
] (3.1)
which they compare against the corresponding expost realized variance. This
is given by
RV
t,T
=
365
M
M
i=1
_
F
t+i,T
−F
t+i−1,T
F
t+i−1,T
_
2
(3.2)
where M is the maturity in days such that t +M = T. To ensure comparability
of results, M = 30. We refer to (3.1) as discretized MFIV and to (3.2) as realized
variance (RV).
3.2 MFIV using calibrated models
Current implementations of MFIV are inaccurate and numerically instable.
Strangely priced options are dangerous to the stability of direct interpolation
because they enter the calculation of MFIV directly and inﬂuence the inter
polated neighborhood on the surface, multiplying their eﬀects. Strikes outside
[K
min
, K
max
] may be mispriced as well. We propose to step away from cal
culating MFIV from prices directly, rather use them to calibrate a model and
generate a large and dense volatility surface, which is translated into option
8
prices at a density unobserved in practice that serve as a basis for MFIV. This
has several advantages:
• Academics have a thorough understanding of the behavior of parametric
models. Curveﬁtting methods based on splines behave unpredictable and
can generate extreme outliers. Option prices can easily become negative.
Additional procedures are necessary to make sure that the interpolation
stays within reasonable boundaries. A calibrated model fulﬁlls these con
ditions by design.
• Calibrated models replicate the behavior of option prices far outofthe
money better than constant extrapolation. MFIV considers a crosssection
of prices that are weighted by K
2
, thus strikes far from the forward price
are less important for the calculation, but in situations where all observ
able strikes are truncated close to the forward price, truncation errors may
be considerable.
• If only one strike is observable (not uncommon – see table 1), the indi
rect approach is still able to approximate the dynamics of the volatility
surface. Constant extrapolation would not only be as informationally inef
ﬁcient as common atthemoney implied volatility, but also introduce the
approximation as a new source of error.
• Parametric models follow from economic reasoning and empirical analy
sis. Standard curveﬁtting methods are not speciﬁcally designed for op
tion markets. Economic reasoning may improve accuracy where educated
guesses are required by the real world.
Choosing the underlying model, we follow Gatheral (2006), who suggests using
a stochastic volatility model with jumps in the stock price process (SVJ model).
His reasoning is that while jumps are empirically necessary to explain volatility
9
surface behavior, estimation of simultaneously jumping prices and volatilities
(as with the SVJJ model) is computationally expensive and inaccurate, because
volatility cannot be observed directly and thus estimation of jumps makes ﬁtting
the surface hard. Furthermore, Gatheral (2006) demonstrates that while the
SVJ model increases the ﬁt compared to the Heston (1993) model, improvements
of the SVJJ model over the SVJ model are small
2
.
For every day and maturity, the speciﬁed model needs to be recalibrated.
Even though one would expect that it is suﬃcient to calibrate the model per
stock globally every once in a while and continue for the next dates with lo
cal optimizations, errors grow fast and are cumulative. Every calibration is
therefore performed globally in a two step process: First, adaptive simulated
annealing (ASA) is performed on the SVJ model’s characteristic function to
ﬁnd a set of parameters v
0
, κ, θ, η, ρ, α, δ, and λ that is likely to be close
to the global optimum. Second, pattern search is performed to ﬁnd the local
optimal set, starting from the last set from ASA. By employing the second step,
the very slow transition from a good state to the best state of ASA can be
avoided and the resulting set is likely to ﬁt better. Details and boundaries of
the optimization can be found in the appendix.
With a parameter set for a given t and T an indeﬁnitely dense option price
surface can be calculated. Here, strikes are ranged from $1 to $5000 and spaced
by $2, so the interpolated option price surface contains 2500 prices. As the in
terpolating SVJ model’s stochastic process is known by assumption, this can be
done computationally eﬃcient through fourier inversion
3
. On this surface, op
tion prices are sorted over strikes and the integral of weighted implied variances
2
As characteristic functions are used for calibration, extension of results to the SVJJ or
VarianceGamma model is straightforward. These can be found in Gatheral (2006).
3
See Gatheral (2006) or the appendix for details.
10
is approximated by trapezoidal numerical integration.
The weighting factor K
2
pronounces strikes atthemoney, thus the most im
portant part the model has is the interpolation. Extrapolation of far outofthe
money strikes has a relatively low impact. The underlying model is known, so
the behavior of the surface is stable. The calibration may correct false prices
and ﬁlters the eﬀects of outliers on the estimation. However, only prices for a
speciﬁc date and maturity are considered, so in cases where only one option is
observable, the model may be vastly misspeciﬁed.
4 Empirical Results
4.1 Data
The data to test the proposed methodology are daily historical option prices
from OptionMetrics, starting January 2, 2000, and ending December 31, 2010,
stocks where quotes that start later or end earlier are not considered. Maturity
of options is limited to be between 8 and 365 days to avoid anomalies of very long
term options or shortly before exercise date. All options are American options,
however OptionMetrics corrects these by subtracting an approximation of the
early exercise premium following a binomial tree approach. Even though this
might contain other biases, these are consistent over all analyzed stocks and do
not aﬀect the main results. Furthermore, positive bidask spreads are required.
Stock prices, BlackScholes implied volatilities, and the interest rate curve are
from WRDS and prices are dividend adjusted, but stock splits are not corrected.
From this data set we selected 15 stocks
4
randomly. While other authors (for
example Carr and Wu (2009)) choose stocks according to availability of option
4
The low number of stocks is mainly due to the time intensive computation. Tests will be
extended in future versions of this paper.
11
Table 1: List of stocks in the sample
No. Security ID Ticker Starting Date Sample size Min. Strikes Max. Strikes Name
1 100943 ASA 02Jan1996 9789 4 5 ASA GOLD AND PRECIOUS METALS LIMITED
2 101172 AAI 02Jan1996 3480 1 5 AIRTRAN HLDGS INC
3 101328 TWX 02Jan1996 16889 4 5 TIME WARNER INC
4 101475 ABC 01Aug1998 8120 4 5 AMERISOURCEBERGEN CORP
5 102322 BDN 14Apr1998 886 2 5 BRANDYWINE RLTY TR
6 104939 F 02Jan1996 8013 1 6 FORD MTR CO DEL
7 105964 IDA 28Sep1996 2987 1 4 IDACORP INC
8 106652 KNDL 05Dec1998 3241 1 5 KENDLE INTERNATIONAL INC
9 106776 LSI 02Jan1996 6428 1 5 LSI CORPORATION
10 106892 LM 29Apr1997 11302 4 5 LEGG MASON INC
11 107015 L 02Jan1996 7044 4 5 LOEWS CORP
12 109695 ROL 27Oct1998 333 1 4 ROLLINS INC
13 110681 SYKE 02Apr1997 3477 1 4 SYKES ENTERPRISES INC
14 110740 TE 13Mar1996 3965 3 5 TECO ENERGY INC
15 112219 ZBRA 02Jan1996 5701 4 4 ZEBRA TECHNOLOGIES CORP
Table 1 summarizes the sample of stocks used in this paper. Quotes for calculations start 01Jan2000 and end 31Dec2010. Sample
size refers to the number of observations per stock, minimum and maximum strikes refer to the number of strikes observable for a
chosen maturity.
quotes, this shortage of data is what the proposed methodology is designed for
to overcome. A summary of the used data can be found in table 1.
4.2 Predictive regressions
To assess the forecast ability of both methods we follow Shu and Zhang (2002)
and run regressions on both the method as in Carr and Wu (2009) and the
indirect method on the future realized variance. The regression models are
RV
t
= α + βMFIV
CW
t
+
t
(4.1)
RV
t
= α + βMFIV
CS
t
+
t
(4.2)
where superscript
CW
denotes the Carr and Wu (2009)Method, and
CS
de
notes MFIV from calibrated surfaces. Table 2 summarizes the rsults of both
regressions on MFIV calculations for the ﬁrst trading day of every month on 30
days in the future per security. In most cases, the new method’s R
2
is higher
than before, and Fstatistics as well as pvalue are in favor of the MFIV from
calibrated surfaces. In absolute terms, R
2
seems to be low, but there are two
possible explanations: First, the data is not adjusted for stock splits. This may
introduce an error in the calculation of the variance, depending on the exact
12
adjustment procedure of options. Second, the stocks are selected randomly from
all available stocks in the WRDS database, and may be illiquid or inactively
traded. Both apply to every stock in the data set, and do not aﬀect the results
of the predictive regressions (4.1) or (4.2).e
5 Conclusion
In this paper, we develop a new method to calculate MFIV which does not
directly incorporates prices and is numerically more robust than prior methods.
It speciﬁcally addresses the interpolation/extrapolation method by Jiang and
Tian (2005), which relies on polynomial splines between observed option prices,
which are hard to control and may easily result in negative prices or volatilities.
Furthermore, the assumption of constant strike prices outside the observable
range is unrealistic. By calibrating a SVJ model to option prices, the price
surface can be approximated better, and will stay within boundaries that are
relatively well understood. Instead of taking the volatility from the model itself,
we calculate MFIV from the cross section of option prices, using all available
information. Predictive regressions conﬁrm that the proposed method is indeed
better suited to extract future realized variance from option markets.
There are still issues with the calculation of MFIV from incomplete observa
tions. First, for every considered date, the price surface has to be calibrated
globally. This is not only expensive in terms of computation, but it still requires
some data to calibrate on. In cases where only one or no option prices are ob
servable, the model might be miscalibrated. One way to circumvent this could
be to analyze the stability of model parameters over time, and use them not only
as a starting set for the next ﬁtting, but also to interpolate over time. Second,
empirical evidence points into the direction that volatility follows a continuous
13
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14
process. High frequency data, which has established to be standard for realized
variance estimations, should be analyzed in the context of of MFIV. This may
also improve ones ability to interpolate over time, as parameters are likely to
be more stable over 5 minutes than over 30 days.
It seems promising to apply the proposed methodology to estimate the vari
ance risk premium. With a more accurate estimation, a part of what is un
derstood as premium might be identiﬁed as measurement error. Further tests
could check wether classic risk factors inﬂuence the variance risk premium, or
wether current risk factors are brought into existence by variance risk premia.
A Calibration of SVJ model
A.1 Derivation of the Valuation Equation
In general, the price of a European call option can be computed as
C(F
t
, τ) = e
−rτ
E
Q
[max(F
T
−K, 0)] (A.1)
It turns out that it is quite straightforward to get option prices by inverting the
characteristic function of a given stochastic process if it is known in closed form:
C(F
t
, τ) = F
t
−
_
F
t
K
1
π
_
∞
0
Re
_
e
iux
t
φ
τ
(u −
i
2
)
¸
u
2
+
1
4
du (A.2)
where φ
T
(u) is the characteristic function of S and x
t
= log
_
F
t
K
_
. In the fol
lowing, we’ll follow the derivation of Carr and Madan (1999) and Lewis (2000)
to derive (A.2).
A covered call G(x
t
, τ) is a long position in S and a short position in a call
option C(S, τ) written on S with payoﬀ G(k, 0) = min(S
T
, K) = min(F
T
, K).
15
To derive (A.2), consider the Fourier transform payoﬀ of G(k, τ) with respect
to the logstrike k = log
_
K
F
t
_
= −x deﬁned by
ˆ
G(u, τ) =
_
∞
−∞
e
iuk
G(k, τ)dk (A.3)
Then
1
F
ˆ
G(u, T −t) =
_
∞
−∞
e
iuk
E
_
min(e
x
T
, e
k
)x
t
= 0
¸
dk
= E
__
∞
−∞
e
iuk
min(e
x
T
, e
k
)dk
¸
¸
¸x
t
= 0
_
= E
__
x
T
−∞
e
iuk
e
k
dk +
_
∞
x
T
e
iuk
e
x
T
dk
¸
¸
¸x
t
= 0
_
= E
_
e
(1+iu)x
T
1 + iu
−
e
(1+iu)x
T
iu
¸
¸
¸x
t
= 0
_
only if 0 < Im[u] < 1!
=
1
u(u −i)
E
_
e
(1+iu)x
T
¸
¸
x
t
= 0
_
=
1
u(u −i)
φ
T
(u −i)
To get the call option price in terms of the characteristic function, we express
the option in terms of the covered call position and invert the Fourier transform,
integrating along the line Im[u] =
1
2
.
C(F, τ) = F −G(F, τ)
= F −F
1
2π
_
∞+
i
2
−∞+
i
2
e
−iuk
u(u −i)
φ
T
(u −i)du
= F −F
1
2π
_
∞
−∞
e
−i(u+
i
2
)k
(u +
i
2
)(u −
i
2
)
φ
T
(u −
i
2
)du
= F −
√
FK
1
π
_
∞
0
Re
_
e
iux
t
φ
T
(u −
i
2
)
¸
u
2
+
1
4
du
16
A.2 Used characteristic functions
As in Gatheral (2006, Chapter 5).
A.2.1 BlackScholes GBM
In the BlackScholes model, the dynamics are given by
dS = µSdt + σSdW (A.4)
The characteristic function is given by
φ
T
(u) = exp
_
iu(µ −
1
2
σ
2
)T −
1
2
u
2
σ
2
T
_
(A.5)
A.2.2 Merton Jump Diﬀusion
In the jumpdiﬀusion model, the dynamics are assumed to be
dS = µSdt + σSdW + (J −1)Sdq (A.6)
where
dq =
_
¸
¸
_
¸
¸
_
0 with probability 1 −λdt
1 with probability λdt
is a homogeneous Poisson process with arrival intensity λ and the jump size
J assumed to be lognormally distributed with mean logjump α and standard
deviation δ. The characteristic function is given by
φ
T
(u) = exp
__
−
1
2
u(u + i)σ
2
−λ
_
−
_
e
iuα−
u
2
δ
2
2
−1
_
+ iu
_
e
α+
δ
2
2
−1
__
_
T
_
(A.7)
17
A.2.3 Heston Stochastic Volatility
The derivation of the characteristic function in the Heston model is somewhat
involved. It is given by
φ
T
(u) = exp{C(u, τ)θ + D(u, τ)v
0
} (A.8)
where
C(u, τ) = κ
_
r
−
τ −
2
η
2
log
_
1 −ge
−dτ
1 −g
__
D(u, τ) = r
−
1 −e
−dτ
1 −ge
−dτ
g =
r
−
r
+
r
±
=
b ±d
η
2
d = d =
_
b
2
−4ac
c =
η
2
2
b = κ −ρηiu
a = −
u
2
2
−
iu
2
A.2.4 Stochastic Volatility with Jumps
To add jumps to the stochastic volatility Heston model, it is combined with the
jump part of the Merton model by multiplying the characteristic functions such
that
φ
T
(u) = exp
_
C(u, τ)θ + D(u, τ)v
0
−
_
λ
_
−
_
e
iuα−
u
2
δ
2
2
−1
_
+ iu
_
e
α+
δ
2
2
−1
___
τ
_
(A.9)
18
Derivations of the characteristic functions above as well as for the SVJJ and
the VarianceGamma model can be found in Gatheral (2006).
A.3 Adaptive simulated annealing
For the ﬁrst step of the calibration, the last best set is used after either the
root mean squared error change over 500 iterations is smaller than 1e −6 or the
algorithm has evaluated 24000 sets.
In the calibration of the SVJ model, the the parameters are limited to
0.01 ≤ v
0
≤ 1; 1 ≤ κ ≤ 20; 0.01 ≤ θ ≤ 1; 0.01 ≤ η ≤ 1;
−1 ≤ ρ ≤ 1; −1 ≤ α ≤ 0; 0 ≤ δ ≤ 1; 0 ≤ λ ≤ 1
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19
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20
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