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Derman - Modeling Vol Smile
Derman - Modeling Vol Smile
Stanford.Smile.fm
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Black-Scholes
S&P 1995
Term structure of strike and expiration, which change with time and market level
Stanford.Smile.fm
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ln ( K S )
as a function of moneyness --------------------- or
it steepens with maturity
Foresi & Wu: Journal of Derivatives, Winter 2005
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RE
EXHIBIT 5
TO
LE
IL
Corr(c0,c1)
0.3
0.5
0.2
GA
0.2
0.4
0.4
0.1
IS
0.6
0.7
0
0.2
0.4
IT
0.6
0.8
0.8
0.9
0.5
1.5
2.5
Maturity in Years
3.5
4.5
0.5
1.5
2.5
3.5
4.5
Maturity in Years
Lines denote the cross-correlation estimates between the volatility level proxy (c0) and the volatility smirk slope proxy (c1). The left panel measures the correlation based on daily estimates, the right panel measures the correlation based on daily changes of the estimates.
Stanford.Smile.fm
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Short-term implied volatilities are more volatile. This suggests mean reversion or stationarity for
the instantaneous volatility of the index.
Stanford.Smile.fm
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Other Markets
VOD Imp Vol (12/27/01)
70%
Imp Vol
60%
1 Mon
3 Mon
50%
6 Mon
12 Mon
40%
30%
0.5
0.75
1.25
1.5
Strike/Spot
USD/EUR
MXN/USD
JPY/USD
Stanford.Smile.fm
9.85
123.67
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dC BS ( S, t, K, T, )
C BS C
+
= --------------------------------------------- =
S
dS
S
C S T
---------- 400
0.02
---------- 0.0002
S K 100
Eq.1.1
C
400 0.0002 = 0.08
S
For a typical move S 10 S&P points the hedging error = 0.8 points
2
1
S
1 S
The P&L earned from perfect hedging is -------- -------------- -------- --------- ( 50 ) = 0.25 points ,
2
200
S T 2
which is dwarfed by the error.
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Behavioral Causes
Crash protection/ Fear of crashes) [Katrina]
Out-o- money puts rise relative to at-the-money; so do realized volatilities
Expectation of changes in volatility over time
Support/resistance levels at various strikes
Dealers books tend to be filled by the demand for zero-cost collars
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Physics is about the future; finance is mostly about expectation of the future.
Absolute valuation
Newton in physics; no such thing in finance
A model is only a model: capture the important features, not all of them.
Stanford.Smile.fm
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The best way to handle valuation in the presence of a smile is to use no model at all. For
terminal payoffs:
Any of these payoffs can be exactly duplicated by a linear combination of forwards, bonds, puts
and calls with a range of strikes, and hence exactly replicated at a cost known if we know the
volatility smile.
Replication will hold irrespective of jumps, volatility, etc. -- only problem is counterparty risk.
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Eq.1.2
Calibration: ( S, t ) ( S, t, K, T ) ?
Even if there is a solution, does the local volatility describe the asset?
CEV models: dS = ( S, t )dt + S dZ but they are parametric and cannot match the
implied volatility surface
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Interest rates: long rates are averages of expected future short rates between today and maturity
strike K
local volatility (S,t)
spot S
T
S=K
1
--- ( S )
2
S=K
Local volatilities predict \ the change of implied volatility with stock price, and that local volatility
varies twice as fast with spot as implied volatility varies with strike.
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( S, K )
( 80, 100 )
( 100, 80 )
( 100, 100 )
80
100
S = 80
S = 100
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p ( S, t, K, T ) = e
r(T t)
(C ( S, t, K, T ))
K
We can go further than this, and actually find the local volatility ( S, t ) from market prices of
options. For zero interest rates and dividends, the local volatility at S T = K can be determined
from the derivatives of option prices:
C ( S, t, K, T )
T
( K, T )
--------------------- = ------------------------------------2
2
2 C
K
2
K
2
Stanford.Smile.fm
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implied
vol vs. strike
0.25
0.2
implied
vol vs. strike K
0.15
0.1
0.05
spot or strike
60
Stanford.Smile.fm
80
100
120
140
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Local Volatility
In practice, we dont have a continuous implied volatility surface so we cannot use these
relations blindly. Needs more sophisticated methods.
Nice approximate harmonic average relation for short expirations due to Roger Lee:
x = ln ( S K )
x
1 1
1
----------- = --- ----------- dy
x (y)
(x)
o
Stanford.Smile.fm
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V =
E [ dWdZ ] = dt
Option prices are risk-neutral, volatility is not -- need market price of risk for volatility.
Can one really know the stochastic PDE for volatility? A tall order. (Rebonato).
Stanford.Smile.fm
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1
C SV = --- [ C BS ( S, K, H ) + C BS ( S, K, L ) ]
2
H
L
K
C SV = Sf ---- SC BS ( S, K, )
S
So
K
= g ----
S
at the money
S
K
Stanford.Smile.fm
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( S, K )
( 100, 80 )
( 100, 100 )
( 80, 80 )
( 100, 120 )
S = 100
( 80, 100 )
S = 80
80
Stanford.Smile.fm
100
120
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= ( m )dt + dW r
Heston, etc.
Su,u
Su,d
S,
Sd,u
Sd,d
V
V
V 1--- V 2 2 1--- V 2 V
+
qS + rS + ( S, , t ) rV = 0
S +
q +
2 2
S
S
t 2 S2
Risk neutrality: volatility drift or market price of risk is determined by options prices being riskneutral.
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1 2
T = --- t dt
T
V =
p ( T ) B S ( S, K, r, T, T )
H
L
Stanford.Smile.fm
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Imp
Vol
=0
= -1
> -1
strike
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Jump-Diffusion Models
In fact, not only is volatility stochastic, but more seriously, stock prices move discontinuously.
Geometric Brownian motion isnt the right description.
Merton: Poisson distribution of unhedgeable but diversifiable jumps.
S+J
BS
1-
BS
SK
C JD
2
1
1 2
2
n J + ---
n
-J
+
2 J
2 n J
2 J
( )
-C BS S, K, , + ---------, r + --------------------------- e
= e
1
-----------
n!
n=0
Stanford.Smile.fm
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Jump-Diffusion Smiles
0.285
0.28
implied volatility
0.275
0.27
0.265
0.26
"0.1"
"0.4"
"100"
0.255
0.25
0.245
0.24
0.235
-0.1
-0.1
0
0.05
0.1
Stochastic volatility, in contrast, has difficulty
ln(K/S)
producing a steep short-term smile because the
volatility diffuses, and therefore doesnt
change too much initially. The smiles in a stochastic volatility model are more pronounced at
longer expirations.
Stanford.Smile.fm
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Practitioners think of options models as interpolating formulas that take you from known prices
of liquid securities to the unknown values of illiquid securities:
options;
convertible bonds.
Find a static hedge composed of a portfolio of vanilla options that approximately replicates the
payoff or the vega of the exotic options.
Then figure out the value of the portfolio of vanilla options in a skewed world.
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Summary
The best you can do is pick a model that mimics the most important behavior of the underlyer in
your market. Then add perturbations if necessary.
There is lots of work to be done on modeling realistic distributions and the options prices they
imply.
Stanford.Smile.fm