Lecture4.2010. Courseworks

E4718 Spring 2010: Derman: Lecture 4:More on The Smile: Arbitrage Bounds, Valuation Problems, Models
Page 1 of 38
Lecture 4:
More on The Smile: Arbitrage Bounds,
Valuation Problems, Models
Summary of Lecture 3:
Hedging at different volatilities
Hedging at an arbitrary constant volatility, assuming (unrealistically) that all
volatilities are known:
T
1 r ( t t0 )
2
2
2
PV ( P&L ) = V h V i + --- e
h S ( r h )dt
2
t0
If you hedge at realized, your total P&L is deterministic but has uncontrollable
random changes along the way to expiration.
If you hedge at implied, the P&L predictable at each instant, but path-dependent and thus the total P&L is unknown.
Hedging discretely
If you hedge discretely at the wrong volatility, hedging more often doesnt
decrease your error because of the random nature of the P&L from terms linear
in the stock price movements.
If you hedge at the right volatility, with h = r = i , then the hedging error
goes to zero like n
0.5
as the number of rebalancings n .
Intuitively: error is proportional to uncertainty in sampled volatility
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C
------
n
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The Effect Of Transactions Costs

When the stock moves, you need to readjust your delta from
C
at time t to the
S
value at time t + t by the amount
C
S
S shares, which costs an amount
S S dollars, for proportional transactions costs. These costs subtract

2
S
from the value of a long position and add to the value of a short one.
If you are long an option, you have to short stock against it in order to hedge,
and therefore this cost subtracts from the value of the payoff you receive from
convexity, and so reduces the value of your P&L, and hence effectively makes
the options have a smaller volatility.
If you are short the option and hedge it by going long stock, being short convexity you lose money when the stock moves, and these costs adds to the
amount you lose, so the option is a bigger expense and the quoted volatility is
effectively greater.
Hedge more frequently: replicate better, greater cost.
Hedge less frequently: replicate worse, less cost.
2
No transactions cost: T ( t ) rehedges, each rehedge has variance O ( [ t ] ) ,

so total variance is O ( t ) and hedging error ( t
0.5
) , converges to zero.
With transactions cost and regular rehedging: T ( t ) rebalancings at cost

O ( t
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0.5
) for a total cost hedging cost ( t
0.5
) , diverges.
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This Lecture:
Transactions costs PDE approximation
Different Smiles in Different Markets
Variation of implied volatility and the smile over time
Consequences of the Smile for Trading
and the Smile
The Relationship between and Strike
No-Arbitrage Bounds on the Smile
Problems Caused By The Smile
Some Behavioral Reasons for an Implied Volatility Skew 22
An Overview of Smile-Consistent Models Local Volatility Models 24
Static Hedging and Implied Distributions
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4.1 Recap: A PDE Model of Transactions Costs

One can approach transactions costs even more analytically in the framework
of Hoggard, Whaley & Wilmott (see Wilmotts book Derivatives.)
Let
dS = Sdt + S dt
where is drawn from a standard normal distribution. From Lecture 2, the
P&L of a hedged position when one includes transactions costs is given by
dP&L = dV dS cash spent on transactions costs
2
V
V
1 2 2 V 2
dt + dS + --- S
Z dt dS S N
=
2
t
S
2
S
2
V
V
1 2 2 V 2
Z dt S N
=
dt + ( Sdt + SZ dt ) + --- S
2
S
t
2
S
2
1 2 2 V 2
V
V
V
= SZ dt + --- S
Z + S + dt S N
2
S
t
2
S
where we have set the dividend yield D and the riskless rate r to zero, N is the
number of shares traded to rehedge the initially riskless portfolio at the next
interval, and the modulus sign reflects the fact that transactions costs are paid
for both buying and selling shares.
Now we hedge the initial portfolio by choosing as usual =
V ( S, t ) . After
S
time t we have to rehedge, so that

N ( S, t ) =
V ( S + S, t + t ) V ( S, t )
S
S
2
V
S
V
S
SZ t
to leading order in t , and notice that N itself is stochastic and related to of

course. Our hedge is not a perfect riskless hedge.
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Approximately, therefore, the average number of shares traded is

2
E [ N ] V SE Z
2
S
2
--- V S t
2
S
t =
with an average transactions cost obtained by multiplying the above by the cost
S per share, to yield the cost
2
2 V
2
--- 2 S t
S
The expected value of the change in the P&L is therefore given by
2
1 2 2 V 2 V
2 V
2
dE [ P&L ] = E --- S
Z
+
------S
dt
2
2
t
t
2
S
S
2
1 2 2 V 2 V
2 V
2
--- S
Z
+
------S
dt
2
t
t S 2
2
S
This isnt riskless, but rather stochastic. We are going to assume, as does Wilmott, that even though the portfolio isnt riskless, the holder of this not-quitehedged portfolio would expect to earn the riskless rate. In that case, since the
value of the hedged portfolio is V S
V
, the expected value of the portfolio a
S
V
time dt later should be r V S dt .
S
Inserting this expression into the LHS of the equation above leads to the equation
2
V 1 2 2 V 2
2
V
2
+ --- S
Z -------- V S + rS rV = 0
2
t 2
t 2
S
S
S
Eq.4.1
This is a modification of the Black-Scholes partial differential equation with a

2
nonlinear additional term proportional to the absolute value of =
.
2
S
Because of the nonlinearity, the sum of two solutions to the equation is not necessarily a solution too; you cannot assume that the transactions costs for a portfolio of options is the sum of the transactions costs for hedging each option in
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isolation. Transactions costs cannot be determined in isolation from the portfolio.

2
For a single long position in a call or a put,
V
S
0 , so we can drop the modu-
lus sign. Equation 4.1 then becomes

2
V 1 2 2 V 2
V
Z + rS rV = 0
+ --- S
2
t 2
S
S
Eq.4.2
where
2
2
2
= 2 -------t
This is the Black-Scholes equation with a modified reduced volatility, first

derived by Leland, and the option is worth less. If you are long, you must pay
less than the fair BS value since the hedging will cost you. For a short position,
the effective volatility is enhanced, given by
2
2
2
= + 2 -------t
When you sell the option you must ask for money because hedging it is going
to cost you.
The effective volatility is
2
-------t
Eq.4.3
For very small t this expression diverges and the approximation becomes
invalid.
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4.2 More About The Smile

The Columbia Smile Generated by a Truck with Stochastic Volatility in
2004
4.2.1 Equity index smiles: a reminder

Since the 87 crash there has been a persistent skewed structure in BlackScholes implied volatilities in most world equity option markets.
Representative implied volatility skews of S&P 500 options. (a) Pre-crash. (b)
Post-crash. Data taken from M. Rubinstein, Implied Binomial Trees J. of
Finance, 69 (1994) pp. 771-818.
(a)
Pre-crash
20
V olatility
18
16
14
0.95
0.975
Post-crash
20
1.025
Strike/Index
1.05
18
16
14
0.95
0.975
1.025
1.05
Strike/Index
The Black-Scholes model assumes that volatility is independent of strike and

time to expiration. But the Black-Scholes model has no simple way of allowing
the implied volatility of the stock to depend upon the option strike or time. The
stocks volatility cannot be influenced by the option whose price you quote.
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Here is an old but typical S&P smiles plotted against strike K.
S&P
September 27,
1995.
Strike
Oct. 1 2007
Jan. 24 2008
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short-term implieds
move more
than long-term
negative correlation
during crisis
From Fenglers book
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FIGURE 4.1. Implied Volatility as a Function of Strike/Spot for Different

Expirations. (Crash-o-phobia: A Domestic Fear Or A Worldwide Concern?
Foresi & Wu JOD Winter 05
The quoting convention is the Black-Scholes implied volatility

EXHIBIT 2
Implied Volatility Smirk on Major Equity Indexes
20
T
A
M
28
26
FO
R
25
30
24
22
20
18
Average Implied Volatility, %
30
14
85
90
95
100
105
110
115
120
80
85
90
SixMonth Options
22
20
16
26
24
22
20
90
95
100
105
110
115
TH
85
14
80
120
28
O
R
EP
22
20
18
85
90
95
100
95
100
105
110
115
120
115
120
Strike in Percentage of Spot
30
30
24
90
ThreeYear Options
TwoYear Options
26
85
28
26
24
22
20
18
105
110
115
120
80
85
90
95
100
105
110
FourYear Options
FiveYear Options
32
LE
30
26
IL
IS
120
18
16
14
115
28
IS
18
24
22
20
18
80
120
TI
24
28
115
26
30
110
28
80
105
LE
30
30
80
100
OneYear Options
32
16
IT
95
IN
80
16
15
The slope of
implied volatility
against strike as a
percentage of spot
is negative, even
for long maturities, though not as
steep as for short
maturities.
35
TO
out-of-the-money
puts have higher
implied BlackScholes volatilities than out-ofthe-money calls.
(Why?)
ThreeMonth Options
34
32
OneMonth Options
40
Notice the patterns

that persist across all
indexes:
28
26
24
22
20
18
85
90
95
100
105
110
115
120
80
85
90
95
100
105
110
Lines represent the sample averages of the implied volatility quotes plotted against the xed moneyness levels dened as strike prices as percentages of the spot level. Different panels are for options at different maturities. Data are daily from May 31, 1995, to May 31, 2005, spanning
2,520 business days for each series. The 12 lines in each panel represent the 12 equity indexes listed in Exhibit 1.
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Moneyness, d
NKY
Moneyness, d
FTS
Moneyness, d
AEX
L
A
TO
25
26
27
28
29
30
31
32
33
34
35
25
26
27
28
29
30
31
32
33
34
14
16
18
20
22
24
Moneyness, d
E
C
U
D
OMX
Moneyness, d
HSI
Moneyness, d
PR
E
R
2
short maturity
long maturity
ALO
18
20
22
24
26
28
30
IS
TH
20
3
22
24
26
28
30
32
20
22
24
26
28
30
32
34
Moneyness, d
SMI
Moneyness, d
LE
C
I
T
R
IBE
Moneyness, d
CAC
16
18
20
22
24
26
28
30
32
22
24
26
28
30
32
IN
20
3
25
30
35
Moneyness, d
SPX
Moneyness, d
MIB
Moneyness, d
Y
N
G
E
L
T
A
R
O
F
DAX
Lines denote the sample averages of the implied volatility quotes, plotted against a standard measure of moneyness d = ln(K/S)/( ) where
K, S, and denote the strike price, the spot index level, and the time to maturity in years, respectively. The term represents a mean volatility
level for each equity index, proxied by the sample average of the implied volatility quotes underlying each equity index. For each equity index,
we plot the implied volatility smirks at the 8 different maturities in the same panel. The maturities for each line are 1 month, 3 months, 6
months, 1 year, 2 years, 3 years, 4 years, and 5 years. The length of the line shrinks with increasing maturity, with the longest line representing
the shortest maturity (1 month). The 12 panels correspond to the 12 equity indexes.
22
23
24
25
26
27
28
29
30
31
32
16
18
20
22
24
26
28
30
32
24
26
28
30
32
34
36
38
40
Maturity Pattern of Implied Volatility Smirks




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EXHIBIT 3
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Strike
FIGURE 4.2. Implied Volatility as a Function of log -------------- ( )
Spot
related to d1
When plotted against the number of standard deviations between the log of the
strike and the log of the spot price for a lognormal process, the slope of the
skew actually increases with expiration. Whatever is happening to cause this
doesnt fade away with future time.
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FIGURE 4.3. Behavior of implied volatility level c 0 as a function of option

expiration.
c0
0.3
Sample Average
Sample Average
0.28
0.26
0.24
0.22
term structure of
implied volatility is
roughly flat
0.2
0.18
0.16
0.5
1.5
2.5
3.5
4.5
Maturity in Years
c0
0.16
volatility of volatility
decreases with expiration,
suggesting mean reversion
or stationarity for the
instantaneous volatility
evolution
Standard Deviation
0.14
0.12
0.1
0.08
0.06
0.04
0.5
1.5
2.5
3.5
4.5
Maturity in Years
c
0
daily autocorrelation of
implied volatility is large,
and larger for longer
maturities
[excitement or depression
tends to continue]
0.998
0.996
Autocorrelation
0.994
0.992
0.99
0.988
0.986
0.984
0.98
0.978
1
1.5
2.5
3.5
4.5
Maturity in Years
0.5
EP
0.982
The cross-correlation between volatility level and slope of the skew is large.
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R
EP
EXHIBIT 5
TO
Cross Correlations between Volatility Level and Smirk Slope

0
0.4
IL
LE
G
A
L
0.1
0.2
0
0.2
Corr( c , c )
0 1
Corr(c ,c )
0.3
0.2
0.4
0.5
IS
0.6
0.7
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.
short-term slope tends to get more negative as volatility increases
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4.2.2 Some characteristics of the equity implied volatility smile
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Volatilities are steepest for small expirations as a function of strike, shallower for longer expirations.
The minimum volatility as a function of strike occurs near atm strikes o

strikes corresponding to slightly otm call options.
Low strike volatilities are usually higher than high-strike volatilities, but
high strike volatilities can also increase.
The term structure can slope up or down.
The volatility of implied volatility is greatest for short maturities, as with

Treasury rates.
There is a negative correlation between changes in implied atm volatility

and changes in the underlying asset itself. [Fengler: = 0.32 for the
DAX in the late 90s, for three-month expirations.]
Implied volatility appears to be mean reverting with a life of about 60 days.
Implied volatility tends to rise fast and decline slowly.
Shocks across the surface are highly correlated. There are a small number
of principal components or driving factors. Well study these effects more
closely later in the course.
Implied volatility is usually greater than recent historical volatility.
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4.3 Different Smiles in Different Markets

Here are some smiles for the S&P 500, plotted a little differently:
one year:
slope ~ 5 volatility pt. per 25% change in strike
Indexes generally have a negative skew. The slope here for a one-year option is
0.05
of order 5 volatility points per 250 S&P points, or about ---------- = 0.0002 . Note
250
that the slope for a 3-month option is about twice as much, which roughly con( ln K S )
firms the idea that the smile depends on --------------------- , because a four-fold
( )
decrease in time to expiration then implied a doubling of the slope of the smile.
The magnitude of the slope of the one-month option volatility is about 23 volatility points per 250 S&P points, or about 0.001.
4.3.1 Single stock smiles

A single stock smile is more of an actual smile with both sides turning up.
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4.3.2 Some currency smiles....

MXN/USD
USD/EUR
JPY/USD
weak
USD
strong Euro
strong
USD
weak peso
ATM Strike = 0.90
9.85
123.67
The smiles are more symmetric for equally powerful currencies, less so for
unequal ones. Equally powerful currencies are likely to move up or down.
There are investors for whom a move down in the dollar is painful, but there
are investors for whom a move down in the yen, i.e. up in the dollar, is equally
painful. Hence, there is a motive for symmetry. FX smiles tend to be more
symmetric and resemble a real smile.
Equity index smiles tend to be skewed to the downside. The big painful move
for an index is a downward move, and needs the most protection. Upward
moves hurt almost no-one. An option on index vs. cash is very different and
much more asymmetric than an option on JPY vs. USD.
Single-stock smiles tend to be more symmetric than index smiles. Single stock
prices can move dramatically up or down. Indexes like the S&P when they
move dramatically, move down.
Interest-rate or swaption volatility, which we will not consider much in this
course, tend to be more skewed and less symmetric, with higher implied volatilities corresponding to lower interest rate strikes. This can be partially understood by the tendency of interest rates to move normally rather than
lognormally as rates get low.
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4.3.3 Variation of implied volatility and the smile over time

Example: here is the behavior of volatility itself as time passes.
Three-Month Implied Volatilities of SPX Options
65
60
55
50
1200
1150
1100
1050
1000
950
900
850
800
750
700
650
S&P
45
40
35
30
at-the-money volatility
25
20
ATM
11-02-98
10-01-98
09-01-98
08-03-98
07-01-98
06-01-98
05-01-98
04-01-98
03-02-98
02-02-98
01-02-98
12-01-97
11-03-97
10-01-97
09-01-97
15
INDEX
Here volatility goes up as the index goes down, and vice versa, but the volatility plotted is the at-the-money volatility ( S, t, S, T ) which is the implied
volatility of a different option each day, because as the index level S changes
the atm strike level changes. ATM volatility is therefore not the volatility of a
particular option you own.
If the indexs negative smile doesnt move as time passes and the index level
changes, then at-the-money volatility will go up when the index goes down
simply because the atm strike moves down with index level, and lower strikes
have higher implied volatilities. Thus, some of the apparent correlation in the
figure above would occur even if ( S, t, K, T ) didnt change with S at all.
How much of the correlation is true co-movement and not incidental?
A NOTE ABOUT FIGURES OF SPEECH: People in the market often talk
about how volatility changed. One must be very careful in speaking about
volatility because there are so many different kinds of volatility. There is realized volatility , at-the-money volatility, and implied volatility for a definite
strike, = ( S, t ;K, T ) which can vary with S,t and K,T. When you talk
about the change in , what are you keeping fixed?
For example, at-the-money volatility is atm = ( S, t ;S, T ) which constrains
strike to equal spot. When you talk about how this moves, its a very different
quantity from volatility of an option with a fixed strike. Its a little like the difference between talking about the yield of the 2016 bond and the yield of the
ten-year constant maturity bond over time. Those are different things: one ages
and the other doesnt.
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The index skews variation with time and with market level
SPX One-Month Skew By Delta

10
1400
1200
25D Put - ATM Vol
1000
6
800
4
25D-50D
SPX
600
2
400
0
200
05/04/99
03/16/99
01/26/99
12/08/98
10/20/98
09/01/98
07/14/98
05/26/98
04/07/98
02/17/98
12/30/97
11/11/97
09/23/97
08/05/97
06/17/97
04/29/97
03/11/97
01/21/97
12/03/96
10/15/96
08/27/96
07/09/96
05/21/96
04/02/96
02/13/96
12/26/95
11/07/95
09/19/95
08/01/95
06/13/95
04/25/95
03/07/95
01/17/95
11/29/94
10/11/94
08/23/94
0
07/05/94
05/17/94
-2
Date
Page 1
More recently, notice how skew varies with atm implied volatility.
S&P atm implied vol and risk reversal
between
-25 delta put and
25 delta call
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4.4 Consequences of the Smile for Trading

What are the consequences of the smile for people concerned with trading and
hedging? The fact that the underlying dynamics of the Black-Scholes model is
incorrect and inconsistent with the smile doesnt really affect the pricing of
standard options, because liquid standard call and put options prices are
obtained from the market and simply quoted via the Black-Scholes formula, no
matter how they were generated, and so the model doesnt really matter that
much for pricing in a market-making or manufacturing business. (The model
does matter if you wanted to generate your own idea of fair options values and
then arbitrage them against market prices, but that is a very risky long-term
business.)
However, if you have a position in standard options that you want to hedge,
then, even if the positions price is known, the hedge ratios are model-dependent, and if you dont get the hedging right then you cannot replicate the option
accurately. Furthermore, if you want to take positions in illiquid OTC exotic
options, their values must be estimated from a model. The question in both of
these cases is of course: which model?
4.5 How to Graph the Smile

We observe implied volatility as a function of strike at a given time t0 when the
stock or index is at S0; that is we are given only the snapshot (S0,t0, K,T). Our
problem is similar to that of yield curve modeling: you see the yield curve at
one instant and wonder what will happen to it later. Similarly, if we are interested in volatility, what we would like to know is its dynamic behavior as a
function of S and t, namely (S,t;K,T), assuming implicitly that the BlackScholes is the customary (and appropriate?) way to indicate value.
We can plot ( ) against strike K, moneyness K/S, forward moneyness K/SF ,
( ln K S F ) ( ) , or even more generally against = N(d1), which depends
on stock price, strike, time to expiration and implied volatility, the function we
are plotting, itself.
Traders usually like to plot the smile against because they believe that the
shape of the smile changes less with time and stock price level when expressed
in that functional form. There are some other good practical reasons for preference too:
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Plotting implied volatilities against immediately indicates the hedge for

an option at that strike.
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Since depends on both strike and expiration, you can compare the
implied volatilities of differing expirations and strikes as a function of single variable.
Finally, is approximately equal to the risk-neutral probability N(d2) that a

standard option will expire in the money d 2 is roughly the number of
standard deviations the stock price must move to expire in the money and
therefore seems to be a sensible measure of moneyness. Plotting implied
volatilities against embodies the notion that what matters for an options
price is how likely it is to move into the money from its current value.
Using the wrong quoting convention can distort the simplicity of the underlying dynamics. Perhaps the Black-Scholes model uses the wrong dynamics for
stocks and therefore the smile looks peculiar in that quoting convention. Thats
the underlying hope behind advanced models of the smile.
An example is the case of a stock price that undergoes arithmetic (rather than
geometric) Brownian motion. A constant arithmetic volatility then corresponds
to a variable lognormal volatility that varies inversely with the level of the
stock price. Plotting lognormal volatility against stock price would obscure the
simplicity of the underlying evolution.
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4.6
Page 21 of 38
and the Smile
4.6.1 The meaning of delta

Suppose that
dS
------ = dt + dZ
S
2
d ln ( S ) = ------ dt + dZ
2
2
where dZ = dt .
Then
2
S
ln -----t = ------ t + t
2
S0
Eq.4.4
where is a normally distributed random variable with mean 0 and standard

deviation 1.
The risk-neutral ( = r ) probability of S t > K is P ( S t > K ) given by
S
K
P ( ln S t > ln K ) = P ln -----t > ln ---S0
S 0
2
K
= P ------ t + t > ln ----
2
S0
2
ln K S 0 ------ t
2
= P > ----------------------------------------------- t
= P [ Z > d2 ] = P [ Z < d2 ]
= N ( d2 )
For small t this is approximately equal to N ( d 1 ) or the delta of a call,
which is therefore approximately the risk-neutral probability of the option finishing in the money at expiration.
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4.7 The Relationship between and Strike

The most popular and liquid option is an at-the-money option, with 0.5.
Why? On the day its sold its a bet that could go either way, with roughly
equal odds, and therefore attractive and relevant to speculating on or hedging
the current positions in the stock. Far out-of-the-money options are also popular for buyers, because theyre like cheap lottery tickets with small probabilities of success. Trading desks dont like to sell them; they are subsequently
illiquid because they have a small (and hard to estimate) probability of expiring in the money. They embody tail risk which is very difficult to price.
A standard measure of the skew is the difference in volatility between an outof-the-money call option with a 25% and an out-of-the-money put with a
25% . This trade long the call and short the put at these deltas is called a
risk reversal.
Whats the relation between the strike or moneyness of an option and its delta?
Traders think about moneyness rather than strike, because moneyness measures the strike relative to where spot is today, which is what matters when you
are trading. What percentage of moneyness corresponds to a given ? Its convenient to measure moneyness in units of standard deviation of the log return
for the relevant expiration.
For simplicity set r = 0. Then C = SN ( d 1 ) KN ( d 2 ) where
d 1, 2
S
ln --K
= ---------- ---------- and = T t
2

At the money, K = S and d 1 = 0.5 , assumed small, so that

1 d1
y2
= N ( d 1 ) = ---------- exp ----- dy
2
2
1
= ---------2
d1
y2
y2
exp ----- dy + exp ----- dy
2
2
0
d1
1
--- + ---------2
2
So, at the money,
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1
1
--- + ---------- ---------- 0.5 + ( 0.4 ) ( 0.5 )
2
2 2
As an example, for a typical annual volatility of 0.2 (20%) and an expiration of
one year, we have 0.5 + 0.04 = 0.54 . (Check for yourself on a BlackScholes calculator that this is approximately the correct delta for an at-themoney option at this volatility.)
Now suppose we move slightly out of the money, so that K = S + S where
S
S
S is small. Then ln --------------- = ln ( 1 + S S ) ------ and so
S + S
S
( S ) S
( S ) S
d 1 ------------------ + ---------- = ------------------ + ---------2
2

where ( S ) S is the fractional move in the strike away from the money, and
is the square root of the variance over the life of the option.
Then for a slightly out-of-the-money option, a fraction ( S ) S away from the
at-the-money level,
d1
1
1
1 ( S ) S
--- + ---------- --- + ---------- ---------- ------------------
2
2 2
2 2

Lets look at a real example. Suppose ( S ) S = 0.01, a 1% move away from
the at-the-money. And also assume T = 1 year and = 0.2.
( 0.4 ) ( 0.01 )
Then 0.54 ---------------------------- = 0.54 0.02 = 0.52
0.2
Thus, decreases by two basis points for every 1% that the strike moves out of
the money for a one-year 20%-volatility call option.
The difference between a 50-delta and a 25-delta option therefore corresponds
to about a 12% or 13% move in the strike price.
The move S to higher index levels necessary to decrease the delta of an initially at-the-money call by 0.29 from 0.54 to 0.25 is approximately given by
1 ( S ) S
-------- ------------------ 0.29or ( S ) S = 0.29 2 0.29 2.5 0.2 0.15
2
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Thus the strike of the 25-delta call is about 115. Actually its about 117 if you
use the exact Black-Scholes formula to compute deltas.
More generally, the change in the of a call for a change in S is approximately

given by
1
( S ) S
---------- ------------------
2

and a one-basis point change in corresponds to a change in ( S ) S of about
0.025 .
The key variable here is the percent move in stock price divided by the square
root of the annual variance. For a greater volatility or time to expiration, the
terminal distribution of the stock is broader, and you need a bigger move in the
strike to get to the same .
Example for a 1-month call with zero interest rates, 20% volatility
Delta
Delta decreases by 0.069 as
strike increases by 1%
Strike
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4.8 No-Arbitrage Bounds on the Smile

You should think of as the parameter that determines options prices via the
model, in the same way as you think of yield to maturity as the parameter that
determines quoted bond prices.
There are no-arbitrage bounds on bond yields. For example, consider zero coupon bonds of maturity T whose price is given by B T = 100 exp ( y T T ) . Nos
suppose B 1 = 90 and B 2 = 91 .Then you can create a portfolio long the one
91
year and short the two year, = ------ B 1 B 2 , for zero cost. Assuming positive
90
yields, after one year the long position is worth more than $100, so if you wait
for B 2 to mature and pay off the face value you have a riskless profit. The necessary absence of riskless profits puts constraints on the yields.
There are similarly constraints on the prices of options which lead to subsequent constraints on the smile.
4.8.1 Some of the Merton Inequalities for Strike

Assume zero dividends, European calls.
1. C S Ke
r ( T t )
Proof: A forward F is worth S K at expiration, and therefore, assuming

r ( T t )
zero dividends and a riskless rate r, it worth S Ke

now. An option
is always worth more than a forward, because it has the same payoff when
S T > K , and is worth more when S T < K .
Diagrammatically:
payoff
forward, delivery K
call option, strike K, is worth
more than a forward with
the same delivery price
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2. For the same expiration, options prices satisfy two constraints on their
derivatives:
2
C
C
> 0,
< 0 and
2
K
K
Proof: Look at payoff of a call spread and a butterfly.
payoff
call spread
C(K) - C(K+dK) > 0
butterfly
C(K-dK) - 2 C(K) + C(K+dK) > 0
C(K) - C(K+dK)
K+dK
K-dK
K+dK
The values of these portfolios are always positive, since they have positive
payoff, and are respectively proportional to the first and second derivatives
of the call price w/r/t strike in the limit as the dK 0 . Therefore these
derivatives must be positive, for actual call prices, independent of a model.
There are similar constraints on European put prices:
2
P
P
>0
> 0 and
2
K
K
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4.8.2 Inequalities for the slope of the smile
P
C
> 0 put limits on the slope of the smile.
< 0 and
K
K
These constraint are true in the Black-Scholes formula with strike-independent
volatility. Now suppose you parameterize actual market call and put prices in
terms of the Black-Scholes formula, and so allow the implied volatility to vary
with strike (and expiration). Then, if volatility were to increase (decrease) with
strike level in the Black-Scholes formula, a too rapid increase (decrease) in
volatility could offset the natural decrease (increase) with strike for a call (put)
and so cause the call (put) price actually increase (decrease) with strike level.
These limits on call- and put-price slopes sets respective limits on the positive
and negative slope of the skew, as illustrated schematically below for call and
put prices at some fixed index level S.
The constraints on
implied
volatility
implied
volatility at
index level S
upper bound on implied volatility

from calls
allowed range
lower bound on implied volatility
from puts
strike
Now lets develop this idea more quantitatively.

C = C BS ( S, t, K, T, r, )
C BS C BS
C
=
+
<0
K
K
K
C BS
r
= S N' ( d 1 ) Ke
N' ( d 2 )
Eq.4.5
C BS
r
e N ( d2 )
N ( d2 )
K
------------ = -----------------------------------=
------------------------- r
K
K N' ( d 2 )
C BS
Ke
N' ( d 2 )
Assume that volatility is small and strike price is at-the-money forward so that
1
S F = K . Then d 2 0 , N ( d 2 ) 0.5 and N' ( d 2 ) ---------- , so that
2
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1
--- ----------K
2K
Eq.4.6
( 1.25 )
--------------K K
Eq.4.7
or
Recall that annualized volatility is measured as volatility of returns per year, so

that 20% volatility means = 0.20
< 0.0043 . Equivalently, the maximum

K
amount that volatility can change for a 1% change in strike without violating
the principle of riskless arbitrage is 4.3 percentage points. For comparison, the
S&P skew slope for one-month options in the figure we showed earlier was
0.001, or 1 volatility point for a 1% change in the strike, only a factor of 4
below the arbitrage limit.
For 1-month options, the bound is
We can also examine the limits for asymptotically short and long expirations.
From Equation 4.5 we see that
N ( d2 )
-------------------------- K K N' ( d )
2
When the strike is at-the-money forward, then as 0

d 2 ---------- 0
2
1
N ( d 2 ) --2
1
N' ( d 2 ) ---------2
and so
1 2
O(
)
K
as 0 .
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As the time to expiration 0 , the slope can diverge no faster than O (
1 2
).
At the other extreme, as , d 2 , and therefore

1 N ( d2 )
1 1
1
----------- --------------- O ------ ------ O ---

K K N' ( d 2 )
as the time to expiration gets large. (To prove the line above we have made use
of the asymptotic relation ( N ( d 2 ) ) N' ( d 2 ) O (
0.5
) as .)
Thus, the slope of the smile can decrease with time to expiration no more
1
slowly than O ( ) .
Reference: Arbitrage Bounds on the Implied Volatility Strike and Term Structures of European-Style Options. Hardy M. Hodges, Journal of Derivatives,
Summer 1996, pp. 23-35.
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4.9 Problems Caused By The Smile

.
The Black-Scholes model assumes constant volatility and cannot account for
the pattern of options prices at a given time. It attributes a different underlying
stock implied volatility to each option with a different strike, but that implied
volatility is not really the volatility of the option; it is the volatility of the stock,
and in the model, a stock must have one lognormal volatility of returns which
cannot know about the options strike. There cannot be many GBM volatilities
for the same stock.
Therefore, Black-Scholes is often simply being used as a quoting mechanism,
rather than a valuation mechanism, similar to the way in which yield to maturity is used in quoting rather than calculating bond or mortgage prices.
What problems does this cause?
4.9.1 Fluctuations in the P&L from incorrect hedging of standard options

If we have the wrong model, then, even if liquid vanilla options prices are
forced to be correct by calibrating the implied volatility parameter to the price,
one is using the wrong model formula to obtain the right (market) price. Therefore the derivatives of the formula are wrong and so are hedge ratios. The price
should reflect the riskless hedging strategy, but it wont.
How large a fluctuation in the P&L will be induced by using the wrong hedge
ratio? Lets make a rough estimate.
Using the chain rule,
C BS C
dC BS ( S, t, K, T, )
+
= --------------------------------------------- =
dS
S
S
Eq.4.8
We make the following approximations and assumptions. At the money, the

vega for the S&P 500 index assuming S ~ 1000 and T = 1 year is given by
C S T
---------- 400
2
We can plausibly estimate
order
2/14/10
on dimensional grounds by guessing that it is of

S
, so that
K
Lecture4.2010.fm
Page 31 of 38
0.02
---------- 0.0002
S K 100
where, as we saw earlier, the right hand side of the equation above is the typical order of the magnitude for the S&P 500 skew.
Then, the mismatch between the true and the Black-Scholes owing to the
skew, using Equation 4.8, is approximately
C BS
C
=
400 0.0002 = 0.08
S
S
For a not uncommon daily index move of 1%, or about 10 S&P 500 index
points, we can compare the mismatch in the P&L from using the wrong delta to
the incremental P&L expected in the Black-Scholes model with perfect hedging.
The mismatch in the P&L from being long or short 0.08 of a share when the
index moves 10 points is about 0.8 index points.
The incremental P&L from the curvature in a position in a perfectly hedged atthe-money one-year option in a Black-Scholes world with a not atypical volatility of 0.2 when the index moves 10 points is of order
2
1 S
1
S
-------- -------------- -------- --------- ( 50 ) = 0.25 points
2
2
200
S T
The mismatch in can cause a large distortion in the incremental P&L from
hedging at each step.
4.9.2 Errors in the Valuation of Exotic Options

Even if the prices of standard calls and puts are known without the need for a
model, the value of exotic options will be incorrect if we calibrate these standard options to the wrong model.
Look for example at a rather simple exotic European-style option V at time t
which pays $1 if S K at time T, and zero otherwise. This serves as insurance
against a fixed loss above the strike K, but not against a proportional loss as in
the case of a vanilla call. It is very hard to hedge this because the payoff oscillates between 0 and 1.
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A graph of the payoff at expiration is shown below.
payoff
V(S)
(1/dK) call spreads
K
K + dK
One can approximately replicate V with a call spread, a long position in a call
with strike K and expiration T and a short position in a call with strike K + dK
and the same expiration. In the limit as dK 0 the call spreads payoff converges to that of the exotic option. (In practice, this is often how exotic traders
hedge themselves, choosing a small value of dK .)
The value of the call spread at stock price S and time to time t is
C BS ( S, K + dK, t, T, ( K ) ) + C BS ( K, S, t, T, ( K ) )
d
------------------------------------------------------------------------------------------------------------------------------ C BS ( S, K, t, T, ( K ) )
dK
dK
where C BS ( S, K, t, T, ( K ) ) is the market price of the call quoted in BlackScholes terms, with ( K ) incorporating the dependence of implied volatility
on K. The total derivative with respect to K includes the change of all variables
with K, including that of the implied volatility.
We can estimate the current value V ( S, K, t, T, ( K ) ) if we know how call
prices vary with strike K:
V ( S, K, t, T ) =
C BS C BS
d
C BS ( S, K, t, T, ( K ) ) =
K
K
dK
For r = 0, = 20%, T t = 1 year, K = S = 1000, and a skew slope 0.0002,
C BS
1
1
= N ( d 2 ) = N --- = --- ---------- --- = 0.46
2
K
2
2 2
C BS S T
---------- 400
V ( 100, 100, 0, 1, 0.2 ) ( 0.46 ) + ( 400 0.0002 )

= 0.46 + 0.08 = 0.54
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The non-zero slope of the skew adds about 16% to the value of the option. This
is a significant difference.
Why does the skew add to the value of the derivative V? Because its a call
spread, and a negative skew means there is less volatility at higher strikes, and
therefore less risk-neutral probability of the stock price moving upwards;
therefore the second, higher leg of the call spread is worth less than when there
is no skew.
How can we fix it or extend Black-Scholes to match the skew and allow us
to calculate all these quantities correctly? What changes can we make? Or,
how, as we did in the above example, can we tread carefully and so avoid our
lack of knowledge about the right model and still get reasonable estimates of
value? Those are the questions we will tackle later in the course.
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4.10 Some Behavioral Reasons for an Implied

Volatility Skew
Think of options trading as the trading of volatility or variance as an asset.
Then there are a number of reasons you can think of that might cause a skew or
smile.
2/14/10
Knowledge of past behavior in options markets suggests a skew in options

would be wise. (How much, though? Whats the fair value?) Out-of-themoney puts provide crash protection cheaply, which may have driven up
implied volatilities after 1987. Also, realized volatility will increase in a
crash, therefore this is self-consistent.
Expectation of future changes in volatility naturally gives rise to a term

structure.
Expectation of changes in volatility as the market approaches certain significant levels can give rise to skew structure. For example, investors perception of support or resistance levels in currencies and interest rates
suggests that realized volatility will decrease as those levels are
approached.
Expectation of an increase in the cross-sectional correlation between the

returns of constitutent stocks in the index as the market drops can cause an
increase in the volatility of the entire index. (Some volatility arbitrage dispersion strategies are based on this.)
An aversion to downward market moves/jumps can produce negative skew.

Dealers tend to be short options because they sell zero-cost collars (short
otm call-long otm put) to investors who want protection against a decline.
This fear of being short options in a crash can lead them to charge more to
protect themselves against gamma losses and increases in volatility after a
downward jump.
Lecture4.2010.fm
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4.11 An Overview of Smile-Consistent Models

We want to model the process that produces a smile. One consideration is
whether to model the stochastic evolution of the underlying asset S and its realized volatility, and then deduce the implicit form of the implied volatility surface ( S, t, K, T ) produced by the model, or whether to directly model the
dynamics of the parametric surface ( S, t, K, T ) . Though the former is more
common, the latter is also possible.
Modeling the stochastic evolution of the stock price and its volatility is more
fundamental, and arbitrage violations are more easily avoidable. But it is difficult to figure out the process that accurately describes stock evolution. As I
mentioned in the initial lecture, financial models are often better aimed at modeling observable variables rather than dropping down several levels to model
unobservable processes and then deducing the behavior of observables from
them. We have to make the difficult choice between modeling implied volatility (a parameter in the Black-Scholes model that incorrectly describes options
values) or dropping down a level and modeling instantaneous volatility, a
quantity whose evolution we know little about.
Traders think in terms of Black-Scholes implied volatility, which they observe
as they make markets every day, so for them it is natural to describe the
dynamics of ( S, t, K, T ) . In addition, changes in implied volatility are relatively easy to observe, so that a model of implied volatility can be calibrated
without too much difficulty. But one has to be careful in modeling the stochastic evolution of directly, because changing changes all options prices, and
we do not want to violate the constraints imposed by no riskless arbitrage.
Analogously, in the interest rate world (and most smile models are inspired by
interest-rate models) you cant just write down any stochastic process you like
for moving the yield curve around because you might generate negative forward rates which violate the no-arbitrage constraints on bond prices. One can
develop Heath-Jarrow-Morton-style models for implied volatilities directly,
and well review these later in the course. In these lectures we will predominantly concentrate on more fundamental lower-level models of the stock price
evolution.
One other comment: from the data weve seen on the smile so far: different
markets have such different smiles that we should probably recognize that it is
unlikely that one grand replacement for Black-Scholes will cover all smiles in
all markets. What may well be important is choosing the right model for the
right market.
Since Black-Scholes is inadequate, the most common models of the smile
extend Black-Scholes to accommodate a wider range of asset evolution.
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4.11.1 Local Volatility Models

Local volatility models were the earliest models of the smile. These models
depart just enough from the Black-Scholes model to become consistent with
the smile.
In the Black-Scholes model the stocks volatility is a constant, independent
of stock price and future time, and in consequence ( S, t, K, T ) = is independent of strike and expiration.
In local volatility models, the stocks realized volatility is allowed to vary
deterministically as a function of future time t and the future (random) stock
price S, so that it takes the functional form ( S, t ) . This function is called the
local volatility function, and leads to an implied volatility that can vary with
strike and expiration. In these models the evolution of the stock price is given
by
dS
------ = ( S, t )dt + ( S, t )dZ
S
Eq.4.9
Note that ( S, t ) is a deterministic function of a stochastic variable S, and so

this is a stochastic volatility model, but of a limited kind.
Local volatility models are one-factor models only the stock price is stochastic and so most of the standard Black-Scholes scheme of perfect replication
in terms of the riskless bond and the stock still works; we can use risk-neutral
valuation methods to obtain unique arbitrage-free option values in a similar
way. This is very attractive from a theoretical point of view. But, is it the right
model, or perhaps putting it better, for which asset is it the right model?
In using any model the first problem is that of calibration: how to choose
( S, t ) to match market values of ( S, t, K, T ) . Well show later how this can
be done in principle. But one must be careful: just because you can fit the diffusive process of Equation 4.9 to match the smile doesnt necessarily mean that
the model is an accurate description. The right model is presumably the one
that (most closely this is imperfect finance, not almost perfect physics)
matches the behavior of the underlying asset.
Nevertheless, right or wrong, there is lots to learn about local volatility models
and were going to spend an appreciable amount of time on them later.
What might account for local volatility being a function ( S, t ) ? One example
is the so-called leverage effect for stocks which models the fact that if a company is leveraged, its volatility should increase as the stock price moves lower
and closer to the level of debt. Here is a simplistic illustration:
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S = AB
Page 37 of 38
assets - liabilities
dA
------- = dZ
A
dS
dA
AdZ
(S + B)
------ = ------- = -------------- = -----------------dZ
S
S
S
S
S = ( 1 + B S )
So, stock volatility increases as stock price decreases.
Constant Elasticity of Variance (CEV) models, developed by Cox and Ross
soon after the Black-Scholes model appeared, are the earliest local volatility
models:
dS = ( S, t )dt + S dZ
Here = 1 corresponds to the usual lognormal case, and = 0 to normal
evolution. You need to be negative and quite large in magnitude to account
for the magnitude of the negatively sloped equity index skew.
The conceptual difference between these parametric models and local volatility
models is that the CEV and leverage models are parametric models that have
only a few parameters and cannot fit an arbitrary smile, whereas local volatility
models are non-parametric, so that ( S, t ) must be numerically calibrated to
the observed smile at time t.
4.11.2 Stochastic Volatility Models

One of the Black-Scholes assumptions that is certainly violated is the supposition that volatility is constant. In stochastic volatility models, the volatility or
variance V of the stock itself is an independent random variable whose evolution is correlated with that of the stock price S.
dS = S ( S, V, t )dt + S ( S, V, t )dZ t
dV = V ( S, V, t )dt + V ( S, V, t )dW t
2
V =
E [ dWdZ ] = dt
If you are allowed to replicate options through dynamic trading only in the
stock and the bond markets, and volatility itself is stochastic, then options markets are not complete and perfect replication of the options payoff isnt possible. The principle of no riskless arbitrage will not lead to a unique price and
you need to know the market price of risk or a utility function for risk and
reward to price options; thats not a preference-free method, and less reliable
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than either static or dynamic replication, and wed like to avoid it here. (Of
course, just because we prefer to avoid it from a theoretical point of view
doesnt mean that the market itself doesnt operate that way.)
If you can trade options, and if you know (or rather assume that you know) the
stochastic process for option prices or volatility as well as the stochastic process stock prices, then you can hedge one options exposure to volatility with
another option, you can derive an arbitrage-free formula for options values.
But assuming that you know all this is, as Rebonato says, a tall order.
An additional objection to stochastic volatility models is that they assume that
the correlation is constant. In fact, correlations are stochastic too, with perhaps a greater variance than volatility. Choosing constant may be too
extreme an assumption.
But, you must start somewhere if you want to get anywhere. So, model we
must. Later in the course well study stochastic volatility models.
4.11.3 Jump-Diffusion Models

Another element that Black-Scholes ignores is the discontinuous movement
(a.k.a. jumps) of stock prices. Jump-diffusion models were first invented by
Merton shortly after Black-Scholes. These models allow the stock to make an
arbitrary number of jumps in addition to undergoing diffusion.
With a finite number of jumps of known size in the model, one can replicate
any payoff perfectly with by dynamic trading in a finite number of options, the
stock and the bond, and so achieve risk-neutral pricing. But if there is an infinite number of jumps of different sizes possible, then perfect replication is
impossible, and though people use risk-neutral pricing, its not strictly correct.
4.11.4 A Plenitude of Other Models

There are many other smile models too, which we may discuss later: mixing
models, variance gamma models, stochastic volatility models of other types,
stochastic implied volatility models
In practise, one has to see which model best describes the market one is working in. You could argue reasonably convincingly that in the real world there is
indeed diffusion, jumps and stochastic volatility! Then, however, you have so
many different ways of fitting the observed smile that the model is non-parsimonious and offers too many choices. In the end, you want to model the market with reasonable (but not perfect) accuracy via a fairly simple model that
captures most of the important behavior of the asset. A model is only a model,
not the real thing.
2/14/10
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E4718 Spring 2010: Derman: Lecture 4:More on The Smile: Arbitrage Bounds, Valuation Problems, Models

as the number of rebalancings n .

Intuitively: error is proportional to uncertainty in sampled volatility

The Effect Of Transactions Costs

value at time t + t by the amount

S shares, which costs an amount

S S dollars, for proportional transactions costs. These costs subtract

No transactions cost: T ( t ) rehedges, each rehedge has variance O ( [ t ] ) ,

With transactions cost and regular rehedging: T ( t ) rebalancings at cost

) for a total cost hedging cost ( t

Transactions costs PDE approximation

Different Smiles in Different Markets

Variation of implied volatility and the smile over time

Consequences of the Smile for Trading

and the Smile

The Relationship between and Strike

No-Arbitrage Bounds on the Smile

Problems Caused By The Smile

Some Behavioral Reasons for an Implied Volatility Skew 22

An Overview of Smile-Consistent Models Local Volatility Models 24

Static Hedging and Implied Distributions

4.1 Recap: A PDE Model of Transactions Costs

time t we have to rehedge, so that

to leading order in t , and notice that N itself is stochastic and related to of

Approximately, therefore, the average number of shares traded is

This is a modification of the Black-Scholes partial differential equation with a

nonlinear additional term proportional to the absolute value of =

isolation. Transactions costs cannot be determined in isolation from the portfolio.

For a single long position in a call or a put,

0 , so we can drop the modu-

lus sign. Equation 4.1 then becomes

This is the Black-Scholes equation with a modified reduced volatility, first

4.2 More About The Smile

4.2.1 Equity index smiles: a reminder

The Black-Scholes model assumes that volatility is independent of strike and

Here is an old but typical S&P smiles plotted against strike K.

From Fenglers book

FIGURE 4.1. Implied Volatility as a Function of Strike/Spot for Different

Foresi & Wu JOD Winter 05

The quoting convention is the Black-Scholes implied volatility

Average Implied Volatility, %

Average Implied Volatility, %

Strike in Percentage of Spot

Average Implied Volatility, %

Strike in Percentage of Spot

Strike in Percentage of Spot

Strike in Percentage of Spot

Average Implied Volatility, %

Average Implied Volatility, %

Average Implied Volatility, %

Strike in Percentage of Spot

Strike in Percentage of Spot

Average Implied Volatility, %

Average Implied Volatility, %

Notice the patterns

Strike in Percentage of Spot

Strike in Percentage of Spot

Maturity Pattern of Implied Volatility Smirks

Average Implied Volatility, %

Average Implied Volatility, %

Average Implied Volatility, %

Average Implied Volatility, %

FIGURE 4.3. Behavior of implied volatility level c 0 as a function of option