Dan Dissertation

THE UNIVERSITY OF CHICAGO
DISPLACED LOGNORMAL AND DISPLACED HESTON VOLATILITY SKEWS:

ANALYSIS AND APPLICATIONS TO STOCHASTIC VOLATILITY SIMULATIONS
A DISSERTATION SUBMITTED TO
THE FACULTY OF THE DIVISION OF THE PHYSICAL SCIENCE
IN CANDIDACY FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
DEPARTMENT OF STATISTICS
BY
DAN WANG
CHICAGO, ILLINOIS
JUNE 2010
To my parents
TABLE OF CONTENTS
LIST OF FIGURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi
LIST OF TABLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
ABSTRACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii
ACKNOWLEDGEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
PUBLICATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 DISPLACED LOGNORMAL PROCESS . . . . . . . . . . . . . . . . . . . . . . . 4
2.1 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Displaced Lognormal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2.1 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2.2 Global behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.3 At-the-money behavior . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2.4 Short-expiry behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3 Displaced anti-Lognormal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3.2 Global behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3 DISPLACED HESTON PROCESS . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.1 Displaced Heston . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.2 Displaced anti-Heston . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.2.3 Generalization of short-expiry behavior . . . . . . . . . . . . . . . . . 20
iii
4 CALIBRATION OF DL AND DH PROCESS . . . . . . . . . . . . . . . . . . . . 22
4.1 Calibration of DL and DH Process . . . . . . . . . . . . . . . . . . . . . . . 22
4.1.1 Calibration of DL process . . . . . . . . . . . . . . . . . . . . . . . . 22
4.1.2 Calibration of DH process . . . . . . . . . . . . . . . . . . . . . . . . 23
4.2 Calibration DL and DH to CEV/SABR . . . . . . . . . . . . . . . . . . . . . 23
4.2.1 CEV and SABR stochastic volatility models . . . . . . . . . . . . . . 23
4.2.2 Calibration of DL to CEV/SABR . . . . . . . . . . . . . . . . . . . . 25
4.2.3 Calibration of DH to SABR . . . . . . . . . . . . . . . . . . . . . . . 26
5 VARIANCE REDUCTION IN MONTE CARLO SIMULATION . . . . . . . . . . 27
5.1 Variance Reduction Using Control Variate . . . . . . . . . . . . . . . . . . . 27
5.1.1 DL or DH as a control variate . . . . . . . . . . . . . . . . . . . . . . 28
5.1.2 Example I: Discretely sampled barrier option under CEV/SABR dy-
namics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5.1.3 Numerical results I: Discretely sampled barrier option under CEV/SABR
dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
5.1.4 Example II: Discretely sampled arithmetic Asian option under SABR
dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.1.5 Numerical results II: Discretely sampled arithmetic Asian option under
SABR dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
5.2 Variance Reduction Combining Control Variate and Importance Sampling . . 35
5.2.1 Importance sampling on options pricing . . . . . . . . . . . . . . . . 35
5.2.2 Drifted DH/DL process . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.2.3 Combine control variate with importance sampling . . . . . . . . . . 37
5.2.4 Example: Discretely sampled barrier option under SABR dynamics . 38
5.2.5 Numerical results: Discretely sampled barrier option . . . . . . . . . 40
6 DISCRETISATION SCHEME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
6.1 Partial Strong Convergency of Stochastic Volatility Process . . . . . . . . . . 44
6.2 Strong Convergence of Mean-reverting CEV Process . . . . . . . . . . . . . . 46
6.3 Discretisation Schemes Used in the Monte Carlo Simulation . . . . . . . . . 48
7 LARGE-EXPIRY IMPLIED VOLATILITY OF DISPLACED LOGNORMAL . . 50
7.1 Large-strike and Large-expiry Behavior . . . . . . . . . . . . . . . . . . . . . 50
7.1.1 Case one: K = S
0
e
xT
, x R/[
1
2
2
,
1
2
2
] . . . . . . . . . . . . . . . 50
7.1.2 Case two: K = S
0
e
xT
, x (
2
/2,
2
/2) . . . . . . . . . . . . . . . 52
7.1.3 Case three: K = S
0
e
xT
. . . . . . . . . . . . . . . . . . . . . . . . . 55
7.2 Fixed-strike Large-expiry Implied Volatility . . . . . . . . . . . . . . . . . . . 56
8 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Appendix
iv
A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
A.1 Appendix: Proof of Theorem 1Global Behavior of Displaced Lognormal . . 63
A.2 Appendix: Proof of Theorem 2At-the-money Behavior of Displaced Lognormal 69
A.3 Appendix: Proof of Theorems 3 and 6Short-expiry Behavior of DL . . . . . 70
A.4 Appendix: Proof of Theorem 4Global Behavior of Displaced anti -Lognormal 71
A.5 Appendix: Proof of Theorem 5At-the-money Behavior of Displaced anti -
Lognormal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
B.1 Appendix: Proof of Theorem 7At-the-money Behavior of Displaced Indepen-
dent Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
B.2 Appendix: Proof of Theorems 8 and 9 Short-expiry Behavior of DH . . . . 78
B.3 Appendix: Proof of Propositions 3.1.2 and 3.2.1Level, Slope and Convexity
of DH Short-expiry Implied Volatility . . . . . . . . . . . . . . . . . . . . . . 80
C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
C.1 Appendix: Proof of Theorem 12Partial Strong Convergency of Stochastic
Volatility Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
C.2 Appendix: Coecients of SABR Satisfy the Local Lipschtiz Condition (*) . . 88
C.3 Appendix: Proof of Proposition 6.2.2 and Theorem 13Strong Convergence
of Mean-reverting CEV Process . . . . . . . . . . . . . . . . . . . . . . . . . 89
D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
D.1 Appendix: Proof of Theorem 14 Large-strike and Large-expiry Asymptotic
of Displaced Lognormal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
D.2 Appendix: Proof of Theorem 15First Order Approximation of Large-strike
Large-expiry Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . 98
D.3 Appendix: Proof of Theorem 16Asymptotic Formula of Black-Scholes Call
Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
D.4 Appendix: Proof of Theorems 17 and 18 Second and Third Order Approxi-
mation of Large-strike Large-expiry Implied Volatility . . . . . . . . . . . . 101
D.5 Appendix: Proof of Theorem 19Large-strike Large-expiry At-the-money Im-
plied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
D.6 Appendix: Proof of Theorem 20Approximation of Implied Volatility when
K = S
0
exp(xT
) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
D.7 Appendix: Proof of Theorem 21Fixed-strike Large-expiry Implied Volatility 103
D.7.1 Asymptotic behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
D.7.2 Monotonicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
D.8 Appendix: Proof of Theorem 22Approximation of Fixed-Strike Large-expiry
Implied Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
v
LIST OF FIGURES
2.2.1 Theorem 3 formula and Exact
imp
for T = 1.0. . . . . . . . . . . . . . . . 8
2.3.1 Theorem 5.1 bounds of
atm
for T = 3.0. . . . . . . . . . . . . . . . . . . 11
3.2.1 Theorem 9 formula and exact
imp
. . . . . . . . . . . . . . . . . . . . . . . 19
imp
for T = 10. . . . . . . . . . . . . . . 51
imp
. . . . . . . . . . . . . . . . . . . . . 53
7.1.3 Theorems 17 and 18 formula and Exact
imp
. . . . . . . . . . . . . . . . . 58
7.1.4 Theorems 17 and 18 formula and Exact
imp
. . . . . . . . . . . . . . . . . 58
imp
for T = 10. . . . . . . . . . . . . . . 59
imp
for T = 7. . . . . . . . . . . . . . . . 59
imp
for T = 20. . . . . . . . . . . . . . . 60
vi
LIST OF TABLES
5.1.1 Percentage reduction of variance, using DL for down-and-out call on CEV 32
5.1.2 Percentage reduction of variance, using DL for down-and-out call on SABR 32
5.1.3 Percentage reduction of variance, using DH for down-and-out call on SABR 32
5.1.4 Percentage reduction of variance, using DL as control for Asian Option on
SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5.1.5 Percentage reduction of variance, using LN as control for Asian Option on
SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5.2.1 Percentage reduction of variance, using importance sampling for down-and-
out call on SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2.2 Percentage reduction of variance, using ISDL and ISDH for down-and-out
call on SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2.3 Percentage reduction of variance, using importance sampling for down-and-
in call on SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.2.4 Percentage reduction of variance, using ISDL and ISDH for down-and-in call
on SABR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
vii
ABSTRACT
We analyze the displaced (anti-)lognormal (DL) and displaced (anti-)Heston (DH) volatility
skew. In particular, for the displaced lognormal, we prove the global monotonicity of the
implied volatility, and an at-the-money bound on the steepness of the downward volatility
skews, which therefore cannot reproduce some features observed in the equity market. A
variant, the displaced anti-lognormal, overcomes this steepness constraint, but its state space
is bounded above and unbounded below. We prove the global monotonicity of its implied
volatility too. For the displaced Heston dynamics, we show that the at-the-money slope has
the same sign as the displacement. Whats more, we give an explicit formula for the DL and
DHs short-expiry limiting volatility skew, which allows direct calibration of their parameters
to volatility skews implied by market data or by other models. In the end, we analyze the
large-expiry limiting volatility of the displaced lognormal and give an asymptotic formula of
it in the region of large-strike and xed-strike respectively.
We propose using the DL/DH dynamics as a control variate, to reduce variance in Monte
Carlo simulations of the CEV and SABR local/stochastic volatility models. We give simula-
tion results to show that a carefully constructed control variate can signicantly reduce the
variance in the Monte Carlo simulations. We further propose a combination of the impor-
tance sampling and the control variate to reduce the variance. Numerical simulations show
that signicant variance reduction can be achieved.
Finally we discuss the convergency of the discretisation schemes of the stochastic pro-
cesses encountered in the Monte Carlo simulations. Under some regularity conditions, we
give a partial strong convergency result for the stochastic volatility process. Moreover, we
give a strong convergency result for the mean-reverting CEV process.
viii
ACKNOWLEDGEMENTS
First and foremost, I am deeply grateful to my advisor, Professor Roger Lee, for sharing
with me his insights and wisdom, for his instructive guidance and invaluable advice, for his
constant support and encouragement over the past few years. Without him, this dissertation
would not be possible.
I am grateful to Professor Steven Lalley and Professor Per Mykland for being on my
committee and for their valuable suggestions and comments. In addition, I thank Professor
Per Mykland for many inspiring discussion on topics of application of Statistics to Finance.
Also, I would like to express my sincere thanks to all the faculty, stu and students
of the Department of Statistics at the University of Chicago. Because of them, I have a
wonderful education here. I feel fortunate to study and pursue my doctoral degree in such
an intellectually stimulating and friendly environment.
I would also like to thank my friends who made my time so enjoyable that I will al-
ways cherish my time here. They are my source of advice and discussion. Particularly, I
would like to thank Xiaohui, Han, Changgee, Wenlong, William, Han, Yibi, Yingying, Oli,
Omar, Baoguan, Zuoheng, Christina, Dale, Winfried, Mike, Minsun and Darongsae. I thank
Nathaniel for proof reading my thesis.
Finally, to my parents, to whom this thesis is dedicated, goes my deepest appreciation.
I thank them for their love, care and support over the years. Words cannot express the
gratitude I owe them. I owe a special thanks to my dearest husband, Zhuo, for his love and
care, for his understanding, support, and for accompanying me through this work.
ix
PUBLICATION
Part of the thesis has been published in Lee and Wang (2009), which include the following
materials: Chapter 2.1, 2.2, 2.3.4, Chapter 4.1.1, 4.2.1, 4.2.2, and the parts related to the
DL process in Chapter 5.
x
CHAPTER 1
INTRODUCTION
Given an empirically-observed or model-generated price of a call or put, the implied volatility
is by denition the volatility parameter for which the Black-Scholes formula recovers the
given option price. Regardless of what process actually underlies the given option price, the
implied volatility provides a canonical language or scale by which option prices are commonly
quoted and compared. At any expiry, the volatility skew meaning the implied volatility as
a function of all strikes captures the full risk-neutral underlying distribution at that expiry,
and hence constitutes a natural framework to understand and to compare distributions.
In particular, comparison can occur between an empirically-observed volatility skew and
a model-generated volatility skew, for the purpose of calibrating the models parameters, or
for the purpose of understanding what empirical features can or cannot be reproduced by
the model. Comparison can also occur, between volatility skews generated by two dierent
models, for the purpose of approximating the features of a more complex model, using a
simpler model.
The lognormal (Black-Scholes 1973) model generates a at implied volatility skew, which
does not agree with the sloping skews observed empirically in equity, FX, and interest
rate markets. Displacing the lognormal (Rubinstein 1983) does generate a sloping implied
volatility skew. Marris (1999), Brigo and Mercurio (2002), Joshi and Rebonato (2003),
and Svoboda-Greenwood (2009), have investigated the displaced lognormal (and extensions
thereof), as a pricing model or as a analytical approximation to other models, motivated
largely by applications to interest rate derivatives. In contrast, we draw motivation mainly
from problems arising in equity markets, such as how to calibrate to volatility skews that
slope downward more steeply than all displaced lognormal skews; and we intend to use the
calibrated process less for its analytical pricing than for its applicability to Monte Carlo
pricing.
First, we bound the level and slope of the implied volatility skews generated by dis-
placed lognormal diusions in various regimes (global, or at-the-money, or short-expiry).
1
We prove, among other results, the global monotonicity of implied volatility, and an at-the-
money upper bound on the absolute slope of downward volatility skews, under displaced
lognormal dynamics, which therefore cannot model some features (non-monotonicity and a
steep downward slope) observed in equity market volatility skews. A variant, the displaced
anti -lognormal, overcomes the steepness constraint, but its state space is bounded above
and unbounded below, unlike stock prices. For the displaced anti -lognormal, we prove the
global monotonicity of implied volatility, and an at-the-money bound for the level and slope
of the implied volatility.
The Heston model (Heston 1993) generates the volatility smile and has an analytical
solution for call and put options. We propose a displaced (anti-)Heston diusion and analyze
its implied volatility. We show that the slope of its at-the-money implied volatility has the
same sign as the displacement and its short-expiry implied volatility lacks the skewness
observed in the equity market; while the displaced anti -Heston diusion overcomes the
skewness problem, its state space is bounded above and unbounded below.
For both the displaced (anti-)lognormal (DL) and the displaced (anti-)Heston (DH) dif-
fusions, we nd an explicit formula for their short-expiry limiting volatility skew. This helps
to calibrate the model to the empirical data or other models. Moreover, for any general
process which is a positive martingale, and its corresponding (anti-)displaced process, we
nd an explicit formula between the short-expiry implied volatilities of the two processes.
In light of these restrictions on what features the DL and the DH can model, we then
exploit the DL or DH, not as a model, but as a control variate, to reduce variance in Monte
Carlo simulation of other models, such as the CEV and SABR local/stochastic volatility
models. Fisher and Tataru (2010) state that During the past few years, practitioners have
settled on a consensus of using a mixed stochastic/local volatility (SLV) model as the market
standard for pricing barrier options. CEV/SABR belong to the SLV family of models so
pricing options under them is of practical importance. We therefore consider pricing barrier
option and Asian option under the CEV/SABR model. We give numerical examples which
illustrate signicant variance reductions, when the control variate on DL/DH is carefully
constructed. Whats more, we explore the combination of the control variate and other
variance reduction technique, particularly importance sampling. We give numerical examples
to show the signicance of the variance reduction.
In the Monte Carlo simulation, most of the stochastic processes can not be exactly
sampled. Thus we refer to discretisation schemes to conduct the Monte Carlo simulation.
2
We discuss the conditions which guarantee the convergence of the discretized process to the
underlying continuous process. These convergence results serve as theoretical foundations
for the Monte Carlo simulation.
Finally, we analyze the large-expiry implied volatility of displaced lognormal dynamics.
We give explicit approximation formula of the implied volatility in the large-strike large-
expiry case and the xed-strike large-expiry case.
Chapter 2 discusses the features of the implied volatility of the DL diusion. Chapter 3
discusses the features of the implied volatility of the DH diusion. Chapter 4 illustrates how
to calibrate the parameters of the DL and DH processes. Chapter 5 discusses how to use DL
or DH processes to construct control variate to reduce variance in Monte Carlo simulations
of option pricing; it also discusses how to combine the control variate with the importance
sampling to achieve variance reduction. Chapter 6 discusses the discretisation schemes used
in the Monte Carlo simulations. Chapter 7 discusses the large-expiry behavior of the implied
volatility of displaced lognormal dynamics. Appendix contains most of the proofs.
3
CHAPTER 2
DISPLACED LOGNORMAL PROCESS
2.1 Implied Volatility
We work under martingale measure, and we either assume zero interest rates, or stipulate
that all prices are quoted as forward prices.
Our denition of the implied volatility skew will refer to the function C
BS
, specied as
follows.
Dene C
BS
: R
3
R
+
R and P
BS
: R
3
R
+
R, where R
:= R\{0} and
R
+
:= (0, ), by
C
BS
(s, k, , T) := sN(d
+
) kN(d
) (2.1)
P
BS
(s, k, , T) := kN(d
) sN(d
+
) (2.2)
d
:=
log(s/k)
T
2
(2.3)
where N denotes the standard normal CDF. We may suppress the last argument (T) of C
BS
.
Denition 1 (Implied volatility). Let X be a process with X
0
> 0. For all positive K, T
such that
(X
0
K)
+
< E(X
T
K)
+
< X
0
, (2.4)
dene the implied volatility of X at (K, T) to be the
imp
> 0 such that
C
BS
(X
0
, K,
imp
, T) = E(X
T
K)
+
. (2.5)
Write
X
imp
(K, T) for this implied volatility, which is well-dened, because C
BS
(X
0
, K, , T)
is strictly increasing on R
+
, and has range ((X
0
K)
+
, X
0
).
We refer to the function
X
imp
(, T) as the implied volatility skew of X at expiry T.
4
2.2 Displaced Lognormal
Denition 2. A process S follows displaced lognormal dynamics, with displacement R,
if
dS
t
= (S
t
)dW
t
, S
0
> , > 0, (2.6)
where W is Brownian motion.
Thus S is a driftless geometric Brownian motion with volatility , and the interval
of points attainable by S is (, ). If modeling a nonnegative underlying such as a stock
price, this model for < 0 will misprice deep-out-of-the-money puts, due to the possibility
of S
T
< 0. This model has further limitations, even for at-the-money contracts, as we will
see later.
For K > , a K-strike T-expiry European call option on a displaced lognormal S has
price
E(S
T
K)
+
= E((S
T
) (K ))
+
= C
BS
(S
0
, K , , T). (2.7)
In general, payos invariant to parallel shifts of the S path and the contract parameters can
be priced using Black-Scholes model valuation methods, but applied to displaced arguments.
2.2.1 Implied volatility
Let us apply Denition 1 to the case that X = S, a displaced lognormal. If 0 then
(2.4) holds for all K, T positive. If < 0, then the rst inequality in (2.4) holds for all K, T
positive, but the second inequality E(S
T
K)
+
< S
0
may fail for small positive K, due to
the nonzero probability that S
T
< 0. We therefore take care to dene the strike interval on
which implied volatility exists. For displaced lognormal S, let
K
S
(T) := {K >
+
: C
BS
(S
0
, K , , T) < S
0
} (2.8)
which is a semi-innite interval, by monotonicity of C
BS
in K. For each T > 0 and each
K K
S
(T), equation (2.5) denes the implied volatility of S to be the
imp
such that
C
BS
(S
0
, K,
imp
, T) = C
BS
(S
0
, K , , T). (2.9)
5
To abbreviate the
S
imp
(K, T) and K
S
(T) notations for displaced lognormal S, we will sup-
press the S superscript, and possibly also the T argument.
2.2.2 Global behavior
Theorem 1 establishes the following global properties of
imp
: If < 0 then
imp
is every-
where strictly decreasing in K, and bounded below by . If > 0 then
imp
is everywhere
strictly increasing in K, and bounded above by . In both cases, the global bounds are also
asymptotes.
Theorem 1 (Global behavior). Implied volatilities in the displaced lognormal model (2.6)
have the following global properties.
1. (Monotonicity in strike). For all T > 0 and K K(T),
sgn
imp
K
(K) = sgn . (2.10)
2. (Upper/lower bound). For all T > 0 and K K(T):
If > 0 then
imp
(K) < . If < 0 then
imp
(K) > . (2.11)
3. (Sharpness of bound). For all T > 0, we have
imp
(K) as K .
Hence sup
KK(T)
imp
(K) = if > 0; and inf
KK(T)
imp
(K) = if < 0.
Proof. Appendix A.1.
Brigo-Mercurio (2001) proves the K = S
0
case of (2.10, 2.11). Theorem 1 extends to all
K K(T).
Remark 2.2.1. Empirical volatility skews are typically not monotonic over the entire range of
strikes; a volatility skew which slopes downward in the central portion of the strike range will
usually still turn upward at suciently large strikes. Theorem 1 proves that the displaced
lognormal cannot reproduce this empirical feature.
6
2.2.3 At-the-money behavior
Theorems 2 and 3 focus on two dierent subsets of the (K, T) domain.
Theorem 2 examines the at-the-money strike K = S
0
. Specically, if T > 0 and S
0

K(T), then dene the at-the-money implied volatility
atm
(T) :=
imp
(S
0
, T), which may
be abbreviated as
atm
. We bound the level
atm
and also the slope of
imp
at-the-money.
By slope we always mean log
imp
/ log K, the strike-elasticity of implied volatility.
Theorem 2 (At-the-money behavior). At-the-money implied volatilities in the displaced
lognormal model (2.6) have the following properties.
1. (At-the-money level). If T > 0 and S
0
K(T) then
atm

_
1 +
||
S
0
_
if 0;
atm

_
1

S
0
_
if 0.
(2.12)
2. (At-the-money slope). If < 0 and T > 0 and S
0
K(T) then
1
2
||
|| + S
0
log
imp
log K
K=S
0
=
N(
atm
T/2) N(
T/2)
(
atm
T/2)
T
atm
<
1
2
e
2
atm
T/8
. (2.13)
Remark 2.2.2. If T 1 and
atm
100%, then (1/2)e
2
atm
T/8
< 0.57. Empirically, however,
equity volatility skews typically slope downward more steeply than 0.57. Indeed, in S&P500
daily data from all dates (19962008) in the OptionMetrics database, the approximate
1
3-
month-expiry at-the-money slope log
imp
/ log K is more negative than 1.29 on 90% of
the days in the sample. Theorem 2 proves that the displaced lognormal cannot reproduce
steepness of this magnitude.
1. Our source is the Volatility Surface data set, which contains volatility skews in-
terpolated by OptionMetrics using kernel smoothing. We approximate the slope as
log(
imp
(K
1
)/
imp
(K
0
))/ log(K
1
/K
0
), where K
1
is the strike of a 0.50-delta call, and K
0
is the
strike of a 0.55-delta call, as computed by OptionMetrics.
7
2.2.4 Short-expiry behavior
Theorem 3 takes the short-expiry T 0 limit of the implied volatility skew, and expresses the
solution explicitly. The K = S
0
case is known (indeed Rebonato (2004) renes the K = S
0
formula, to address the case of T large). The contribution of Theorem 3 is to nd and prove
a short-expiry
imp
formula valid for every strike K >
+
.
Figure 2.2.1: Theorem 3 formula and Exact
imp
for T = 1.0.
60 70 80 90 100 110 120 130 140 150 160
17.5
18
18.5
19
19.5
20
20.5
21
21.5
22
K
P
e
r
c
e
n
t
a
g
e

p
o
i
n
t
s

S
0
=100, (1/S
0
)=20%
=25
=50
Exact
imp
Theorem 3 formula
Theorem 3. For all K >
+
, in the displaced lognormal model (2.6),
lim
T0
imp
(K, T) =
_
_
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
(1 /S
0
) if K = S
0
.
(2.14)
Remark 2.2.3. The formula in the right-hand side of (2.14) provides, moreover, a remarkably
accurate approximation to
imp
(K, T) even for some T not close to 0. Figure 2.2.1 compares
the Theorem 3 formula and the exact
imp
(K, T), at expiry T = 1.0.
8
For some expirations of moderate length, therefore, the log(S
0
/K)/ log((S
0
)/(K))
formula may still facilitate calibration of the displaced lognormal parameters (, ) to an
empirically observed volatility skew, or to a model-generated volatility skew.
2.3 Displaced anti-Lognormal
The previous sections results show that with < 0, the displaced lognormal produces
downward-sloping implied volatility, but not of steepness commensurate with typical equity
options data regardless of how large a negative value takes.
A related process, however, does generate arbitrarily large downward slopes.
Denition 3. A process S follows displaced anti -lognormal dynamics if
dS
t
= (S
t
)dW
t
, 0 < S
0
< , < 0, (2.15)
where W is a Brownian motion.
Thus S is a driftless geometric Brownian motion with volatility > 0, and the
interval of points attainable by S is (, ).
Displaced anti-lognormal pricing calculations have the tractability of the displaced log-
normal. For instance, to price a T-expiry call struck at K < , on a displaced anti-lognormal
S,
E(S
T
K)
+
= E( K ( S
T
))
+
= P
BS
( S
0
, K, , T) = C
BS
(S
0
, K , , T).
(2.16)
So we have formally the same C
BS
formula as in the displaced lognormal case. Here its
rst three arguments are negative, which presents no problem; the C
BS
function is still
well-dened by (2.1). An equivalent way to express the result, without negative arguments,
is C
BS
( K, S
0
, , T).
Recognizing the similarities between the displaced lognormal and anti-lognormal, the
following terminology groups them together:
Denition 4 (DL). A process S which satises either the displaced lognormal (2.6) or the
displaced anti-lognormal (2.15) specication is said to be a DL process.
9
Implied volatility for displaced anti -lognormal S is dened on the strike interval
K
ADL
(S, T) := {K (0, ) : C
BS
(S
0
, K , , T) < S
0
}. (2.17)
For K K
ADL
(S, T), we have
S
0
> C
BS
(S
0
, K, ) = P
BS
( S
0
, K, ) > (( K) ( S
0
))
+
= (S
0
K)
+
,
so (2.4) holds and
S
imp
(K, T) is thereby well-dened. To abbreviate the
S
imp
(K, T) and
K
ADL
(S, T) notations for displaced anti-lognormal S, we will suppress the S superscript,
and possibly also the T argument. Note that we have
P
BS
(S
0
, K,
imp
) = E(K S
0
)
+
= C
BS
( S
0
, K, ||). (2.18)
Consequently,
C
BS
(S
0
, K,
imp
) = E(S
T
K) +P
BS
(S
0
, K,
imp
) = (S
0
K) +C
BS
( S
0
, K, ||).
(2.19)
2.3.2 Global behavior
For the implied volatility under the displaced anti -lognormal, we have the global monotonic-
ity behavior similar to the behavior under the displaced lognormal. This is given by Theorem
4.
Theorem 4 (Global behavior). Implied volatilities in the anti-lognormal model (2.15) de-
creases monotonically in strike. That is, for all T > 0 and K K
ADL
(T),
sgn
imp
K
(K) = sgn . (2.20)
10
Theorem 5 examines the at-the-money strike K = S
0
.
atm
(T) is abbreviated as
atm
. We
bound the level
atm
and also the slope of
imp
at-the-money.
100 150 200 250 300 350
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
a
t
m

atm
(/S
0
1)||
||
Figure 2.3.1: Theorem 5.1 bounds of
atm
for T = 3.0. Process parameters are S
0
= 100, K =
100, = 0.3. The solid blue line is
atm
, the black dashed line is (/S
0
1)|| and the red
horizontal line is at the level of ||. As we can see from the gure, when 2S
0
, we have
atm
> (/S
0
1)||; though when S
0
< 2S
0
, it looks like the two lines coincide with each
other, if we zoom in, we could see that
atm
< (/S
0
1)||.
Theorem 5 (At-the-money behavior). At-the-money implied volatilities in the anti-lognormal
model (2.15) have the following properties.
1. (At-the-money level). If > S
0
, T > 0 and S
0
K
ADL
(T) then
atm

_

S
0
1
_
|| if S
0
< 2S
0
;
atm

_

S
0
1
_
|| if 2S
0
.
(2.21)
2. (At-the-money slope). If > S
0
, T > 0 and S
0
K
ADL
(T) then
1
2
S
0
log
imp
log K
K=S
0

2( S
0
)
e
2
atm
T/8
. (2.22)
11
Remark 2.3.1. = 2S
0
is the critical case. When < 2S
0
, we have
atm
<
_

S
0
1
_
||;
when > 2S
0
, we have
atm
>
_

S
0
1
_
||; the equality happens when = 2S
0
. This could
be explained by using the put-call parity as follows. When K = S
0
and = 2S
0
, we have
(S
T
K)
+
= (K ( S
T
))
+
. (2.23)
If S
t
follows the displaced anti -lognormal dynamics with parameters ( = 2S
0
, ), then using
K = S
0
= K, the right-hand side of (2.23) is P
BS
(S
0
, K, ||) = P
BS
(S
0
, K, ||) =
C
BS
(S
0
, K, ||). Therefore the implied volatility of the process S is exactly ||.
Figure 2.3.1 illustrates the Theorem 5.1 bounds of
atm
. The gure also suggests that
we will not have || as the upper or lower bound for
imp
as in the displaced lognormal case.
Theorem 3 extends to all DL processes:
Theorem 6 (Short-expiry behavior). For all K >
+
in the displaced lognormal model (2.6),
as well as for all K (0, ) in the displaced anti-lognormal model (2.15), the conclusion
(2.14) holds.
The Theorem 6 conclusion, and its derivative with respect to log K, yield the short-expiry
limiting volatility skews level and slope
imp
T0, K=S
0
=
(S
0
)
S
0
,
log
imp
log K
T0, K=S
0
=

2(S
0
)
. (2.24)
This holds under all DL dynamics. The distinction is that under displaced lognormal dynam-
ics, we have < S
0
, hence the short-expiry slope cannot be more negative than 1/2. Under
displaced anti -lognormal dynamics, we have S
0
< , hence (2.24) can produce arbitrarily
steep negative slopes.
12
CHAPTER 3
DISPLACED HESTON PROCESS
3.1 Displaced Heston
Denition 5. A process S follows displaced Heston dynamics, with displacement R, if
dS
t
=
t
(S
t
)dW
t
, S
0
> ,
d
2
t
= (
2
t
)dt +
t
dB
t
,
dB
t
= dW
t
+
_
1
2
dW
t
.
(3.1)
where W
t
, W
t
are i.i.d. Brownian motions and
t
is non-negative for all t > 0.
Thus S follows the Heston model, and the interval of points attainable by S is (, ).
As with the displaced lognormal model, if modeling a nonnegative underlying process such
as a stock price, for < 0 this model will misprice deep-out-of-the-money puts, due to the
possibility of S
T
< 0.
We would like to characterize the implied volatility of displaced Heston dynamics. We will
have similar at-the-money behavior and short-expiry behavior as in the DL case. However,
we will not have the global behavior of implied volatility.
Implied volatility for the displaced Heston S is dened on the following strike interval:
K
DH
(T) := {K >
+
: (S
0
K)
+
< E(S
T
K)
+
< S
0
} (3.2)
For each T > 0 and each K K
DH
(T), (2.5) denes the implied volatility of the displaced
Heston to be
DH
imp
(K, T) > 0 such that
C
BS
(S
0
, K,
DH
imp
(K, T), T) = E(S
T
K)
+
. (3.3)
We will suppress the T argument of
imp
(K, T).
13
Although for the displaced Heston process, we will not have the global behavior that the
slope of implied volatility is determined by the sign of the displacement , we are able to
show that when = 0, this feature still holds. We will prove this for a more general DISV
process, dened as follows.
Denition 6. (DISV) A process S follows displaced independent stochastic volatility dy-
namics, with displacement R, if
dS
t
=
t
(S
t
)dW
t
, S
0
> ,
d
t
= f(
t
)dt + g(
t
)dW
t
,
(3.4)
where W
t
, W
t
are i.i.d. Brownian Motion.
Implied volatility for the DISV S is dened on the following strike interval:
K
DISV
(T) := {K >
+
: (S
0
K)
+
< E(S
T
K)
+
< S
0
}. (3.5)
Using (2.5), for each T > 0 and each K K
DISV
(T), the implied volatility of the DISV
model
DISV
(K, T) is dened such that
C
BS
(S
0
, K,
DISV
imp
(K, T), T) = E(S
T
K)
+
. (3.6)
We can suppress the T in
DISV
imp
(K, T).
Theorem 7. If T > 0 and S
0
K
DISV
(T), the slope of the at-the-money implied volatility
in the DISV model (3.4) has the following property:
sgn
DISV
imp
K
(K)
K=S
0
= sgn . (3.7)
Proof. Appendix B.1.
Remark 3.1.1. The slope of at-the-money implied volatility depends on the assumption that
W
t
, W
t
are independent. It may not hold when this condition is violated.
14
Corollary 3.1.1. If T > 0, S
0
K
DH
(T) and = 0, the slope of the at-the-money implied
volatility in the displaced Heston model (3.1) has the following property:
sgn
imp
K
(K)
K=S
0
= sgn . (3.8)
Proof. With = 0, the displaced Heston model belongs to the DISV family of models.
Durrleman (2004) gives the short-expiry implied volatility of the Heston model as a function
of the strike. We will derive the short-expiry implied volatility of the displaced Heston
model using his results. Particularly, we connect the short-expiry implied volatility of the
displaced Heston model with that of the Heston model, and we give an approximation of the
short-expiry implied volatility level, slope and convexity.
Short-expiry behavior of Heston process
Recall that the Heston process proposed by Heston (1993) as follows.
dS
t
=
t
S
t
dW
t
,
d
2
t
= (
2
t
)dt +
t
dB
t
,
dB
t
= dW
t
+
_
1
2
dW
t
,
(3.9)
where W
t
, W
t
t
For S
t
under the displaced Heston dynamics (3.1), denote

S
t
= S
t
, then

S
t
follows
the Heston dynamics (3.9).
The implied volatility of the Heston process

S
t
is dened on the following strike interval:
K
H
(T) := {K >
+
: (
S
0
(K ))
+
< E(
S
T
(K ))
+
<

S
0
}. (3.10)
H
Heston to be
S,H
imp
(

K, T) > 0 such that
C
BS
(
S
0
,

K,
S,H
imp
(

K, T), T) = E(
S
T

K)
+
, (3.11)
15
where

K = K . We will suppress the

S and T argument of
S,H
imp
(

K, T) as
H
imp
(

K).
A call option on the displaced Heston process starting at S
0
with strike K can be con-
sidered as a call option on a Heston process starting at

S
0
with strike

K:
E(S
T
K)
+
= E((S
T
) (K ))
+
= E(
S
T

K)
+
. (3.12)
We take care here to dene the domain of K to make sure that the implied volatilities
of both the Heston model and the displaced Heston model exist. Combine (3.2) and (3.10)
and dene
K
DHH
(T) = K
DH
(T)K
H
(T) := {K >
+
: (S
0
K)
+
< E(S
T
K)
+
< max(S
0
, (S
0
))}
to be the domain of K.
The notation A(T) B(T) means that A(T)/B(T) 1 as T 0. Durrleman (2004)
shows that, for the Heston model, the near-money short-expiry implied volatility of the
vanilla call with

K-strike, T-maturity and initial value

S
0
can be approximated as
H
imp
(

K, T)
_
2
0
+ a
0
log(
S
0
/

K) + b
0
T
2
+
c
0
2
log
2
(
S
0
/

K), (3.13)
where
a
0
=
2
, b
0
= (
2
0
) +

2

2
0

2
6
(1
2
/4), c
0
=

2
6
2
0
(1
7
2
4
).
Short-expiry behavior of displaced Heston process
When near the expiry, the
imp
is well-dened for both the Heston process and the displaced
Heston process, so K K
DHH
(T). Theorem 8 says that the short-expiry implied volatility
of the displaced Heston model can be expressed in terms of the short-expiry implied volatility
of the Heston model. Proposition 3.1.2 gives the short-expiry implied volatilitys level, slope
and convexity at-the-money.
Theorem 8. For K >
+
, the short-expiry relationship between the implied volatilities of
16
the displaced Heston model (3.1) and the Heston model (3.9) is given as follows.
lim
T0
DH
imp
(K, T) =
_
_
lim
T0
H
imp
(K , T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
H
imp
(K , T) (1 /S
0
) if K = S
0
.
(3.14)
Proposition 3.1.2. For the displaced Heston model (3.1) with = 0, for K >
+
, the
at-the-money implied volatility level, slope and convexity when T 0 are given as follows.
level: (
DH
imp
(K, T))
2
K=S
0
=
_
2
0
+ (
2
0
)
T
2

2
T
12
_
(1 /S
0
)
2
+ O(T
2
),
slope:
log
DH
imp
(K, T)
log K
K=S
0
=

2(S
0
)
+ O(T),
convexity:
DH
imp
(K, T)
K
2
K=S
0
=
c
0
_
H
imp
(S
0
, T)
_
1
2(S
0
)S
0
+
H
imp
(S
0
, T)H(S
0
, ) + O(T),
(3.15)
where c
0
=

2
6
2
0
and H(S
0
, ) =
4
2
5S
0
6S
3
0
(S
0
)
.
Remark 3.1.2. The short-expiry at-the-money slope is

2(S
0
)
, suggesting that when > 0,
the at-the-money slope is positive; when < 0, the at-the-money slope is negative, and
is bounded by
1
2
. We have mentioned in Remark 2.2.2 that the empirical equity volatility
skews typically slope downward more steeply than 0.57. Theorem 3.1.2 suggests that the
short-expiry displaced Heston cannot reproduce steepness of this magnitude.
3.2 Displaced anti-Heston
Remark 3.1.2 says that with < 0, the steepness of the short-expiry implied volatility from
the displaced Heston has an upper bound of
1
2
at-the-money. This means that the displaced
Heston is not a suitable model for the equity data. A related process, however, which is
analogous to the displaced anti -lognormal process, will generate arbitrary large downward
slopes.
17
Denition 7. A process S follows displaced anti -Heston if:
dS
t
= (
t
)(S
t
)dW
t
, 0 < S
0
< ,
d
2
t
= (
2
t
)dt +
t
dB
t
,
dB
t
= dW
t
+
_
1
2
dW
t
,
(3.16)
where W
t
, W
t
t
Thus S follows the Heston dynamics with volatility process
t
, and the interval of
points attainable by S is (, ).
Recognizing the similarities between the displaced Heston and anti-Heston, the following
terminology groups them together:
Denition 8. (DH) A process S which satises either the displaced Heston (3.1) or the
displaced anti-Heston (3.16) specication is said to be a DH process.
Implied volatility for the displaced anti -Heston S is dened on the following strike interval:
K
ADH
(T) := {0 < K < : (S
0
K)
+
< E(S
T
K)
+
< S
0
}. (3.17)
ADH
anti -Heston to be
ADH
imp
C
BS
(S
0
, K,
ADH
imp
(K, T), T) = E(S
T
K)
+
. (3.18)
Denote

S
0
= S
0
,

K = K, then

S is the Heston process (3.9). Implied volatility for
the Heston

S is dened on the following strike interval
K
AH
(T) := {0 < K < : (
S
0

K)
+
< E(
S
T

K)
+
<

S
0
}. (3.19)
AH
(T), (2.5) denes the implied volatility of the Heston to
be
H
imp
C
BS
(
S
0
,

K,
H
imp
(

K, T), T) = E(
S
T

K)
+
. (3.20)
18
Again, to make sure the implied volatilities of both the Heston model and the displaced
anti -Heston model exist, we dene a domain of K as
K
ADHAH
(T) = K
ADH
(T) K
AH
(T) = {K : 0 < K < ,
ADH
imp
(K, T) ,
H
imp
(

K, T) .}
We can suppress the T in
ADH
imp
(K, T) as
ADH
imp
(K), and
H
imp
(

K, T) as
H
imp
(

K).
When near the expiry, the
imp
is well-dened for both the Heston process and the displaced
anti -Heston process, so K K
ADHAH
(T). Theorem 9 gives a relationship between the
short-expiry implied volatilities of the displaced anti -Heston model and the Heston model.
Proposition 3.2.1 gives the short-expiry at-the-money implied volatilitys level, slope and
convexity.
0.25 0.2 0.15 0.1 0.05 0 0.05 0.1 0.15 0.2
0.18
0.185
0.19
0.195
0.2
0.205
0.21
0.215
0.22
0.225
0.23
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y
log(K/S)

T=1/12
S=100,
0
=0.04
ThImpVol
ImpVol
0.25 0.2 0.15 0.1 0.05 0 0.05 0.1 0.15 0.2
0.18
0.185
0.19
0.195
0.2
0.205
0.21
0.215
0.22
0.225
0.23
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y
log(K/S)

T=4/12
S=100,
0
=0.04
ThImpVol
ImpVol
Figure 3.2.1: Theorem 9 formula and exact
imp
. Parameters of the displaced anti -Heston dy-
namics are S
0
= 100,
0
= 0.04, = 0.2, = 0.002, = 0.0175, = 600, = 0. In the left plot,
T = 1 month and in the right plot, T = 4 month. The DH model parameters are chosen to be close
to the ones calibrated from the SABR model using S = 100, = 0.2, S
0
= 0.2, = 0.4, =
0.2, T = 1 year. The details of the calibration are in section 4.1. The dashed black line is the exact
imp
by (3.18). The solid green line is Theorem 9 formula, where
H
imp
( K, T) is approximated
using (3.13).
19
Theorem 9. For K (0, ), the short-expiry relationship between the implied volatilities of
the displaced anti-Heston model (3.16) and the Heston model (3.9) is given as follows.
lim
T0
DH
imp
(K, T) =
_
_
lim
T0
H
imp
( K, T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
H
imp
( K, T) (1 /S
0
) if K = S
0
.
(3.21)
Proof. Appendix B.2
Remark 3.2.1. Figure 3.2.1 compares the Theorem 9 formula and the exact
imp
(K, T), at
expiry T = 1/12 and T = 4/12. It suggests that the formula in the right-hand side of (3.21)
provides, a remarkably accurate approximation to
imp
(K, T) even for T not close to 0.
Proposition 3.2.1. For the displaced anti-Heston (3.16) with = 0, for K (0, ), the
at-the-money implied volatility level, slope and convexity when T 0 are given in the follows.
level: (
ADH
imp
(K, T))
2
K=S
0
=
_
2
0
+ (
2
0
)
T
2

2
T
12
_
(1 /S
0
)
2
+ O(T
2
),
slope:
log
ADH
imp
(K, T)
log K
K=S
0
=

2(S
0
)
+ O(T),
convexity:
ADH
imp
(K, T)
K
2
K=S
0
=
c
0
_
H
imp
( S
0
, T)
_
1
2(S
0
)S
0
H
imp
( S
0
, T)H(S
0
, ) + O(T),
(3.22)
where c
0
=

2
6
2
0
and H(S
0
, ) =
4
2
5S
0
6S
3
0
(S
0
)
.
3.2.3 Generalization of short-expiry behavior
The relationship between the short-expiry
imp
of the Heston process and the DH process
given in Theorems 8 and 9 can be generalized to a relationship between the short-expiry
imp
of any process which is a positive martingale and its corresponding (anti-)displaced
process.
Denote the process X to be a positive martingale.
20
Denition 9. A process S is said to be a displaced-X process, with displacement R, if
S
t
= X
t
, for any t 0.
Denition 10. A process S is said to be an displaced-anti-X process, with displacement
R, if S
t
= X
t
, for any t 0.
Denote
X
imp
(K, T) to be the implied volatility of the process X by (2.5). Denote
DX
imp
(K, T) and
ADX
imp
(K, T) to be the implied volatilities of the displaced-X process and
the displaced-anti-X process. Denote K
X
(T) to be the domain of K where
X
imp
(K, T) and
DX
imp
(K, T) are well-dened as T 0. Denote K
ADX
(T) to be the domain of K where
X
imp
(K, T) and
ADX
imp
(K, T) are well-dened as T 0. Theorems 10 and 11 give the
short-expiry relationship between
X
imp
(K, T) and
DX
imp
(K, T), as well as
X
imp
(K, T) and
ADX
imp
(K, T).
Theorem 10. For a process X which is a positive martingale, for K >
+
and K
K
DX
(T), the short-expiry relationship between the implied volatilities of X and its corre-
sponding displaced-X process is given as follows.
lim
T0
DX
imp
(K, T) =
_
_
lim
T0
X
imp
(K , T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
X
imp
(K , T) (1 /S
0
) if K = S
0
.
(3.23)
Proof. Similar to the proof of Theorem 8.
Theorem 11. For a process X which is a positive martingale, for K (0, ) and K
K
ADX
(T), the short-expiry relationship between the implied volatilities of X and its corre-
sponding displaced-anti-X process is given as follows.
lim
T0
ADX
imp
(K, T) =
_
_
lim
T0
X
imp
( K, T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
X
imp
( K, T) (1 /S
0
) if K = S
0
.
(3.24)
Proof. Similar to the proof of Theorem 9.
21
CHAPTER 4
CALIBRATION OF DL AND DH PROCESS
4.1 Calibration of DL and DH Process
Whether one chooses to use the DL/DH as a model, or as an approximation of another
model, or (as we will) as a control variate for another model, in any case the DL parameters
(, ) and DH parameters (
0
, , , , , ) require estimation/calibration. We use Theorem
6 implications (2.24) to t the DL parameters to a given implied volatility level and slope.
We use Proposition 3.1.2 and Proposition 3.2.1 to t the DH parameters to a given implied
volatilitys level, slope and curvature.
4.1.1 Calibration of DL process
Given a short-expiry at-the-money skew level a and slope b (either from some model, or from
direct empirical measurement), and given an underlying level S
0
, there exists a DL process,
with S
0
= S
0
and parameters (, ), such that the DL skews short-expiry level and slope
(2.24) match the given level a and slope b, provided that b = 1/2. Explicitly, we nd
= a(1 + 2b), =
2b
1 + 2b
S
0
. (4.1)
In the case of slope b > 1/2, the calibrated DL process is a displaced lognormal. In the case
of slope b < 1/2, the calibrated DL process is a displaced anti -lognormal. The singular
case of slope b = 1/2 can be matched by normal or Bachelier dynamics dS
t
= aS
0
dW
t
.
The DL and Bachelier models belong to the family dS
t
= (S
t
+A)dW
t
, where = 0 in the
case of DL, and = 0 in the singular case of Bachelier.
Remark 4.1.1. Although (2.24) is a short-expiry limit, Remark 2.2.3 indicates its accuracy
at T of moderate length. Therefore (4.1) may still facilitate calibration of (, ) to volatility
skews (a, b) even at moderately long expiries.
22
4.1.2 Calibration of DH process
Given a short-expiry at-the-money skew level a, slope b and convexity c (either from some
model, or from direct empirical measurement), and given an underlying level S
0
, there exists
a DH process, with S
0
= S
0
and parameters (
0
, , , , , ), such that the DH skews
short-expiry level, slope and convexity (3.15) or (3.22) match the given level a, slope b and
convexity c, provided that b = 1/2. Recall that we have restricted = 0 in (3.15) and
(3.22). In application, we will also prex . With (, ) prexed, we nd explicitly,
=
2b
1 + 2b
S
0
,
0
= |a(2b + 1)|, =

2
6
+
2
0
=
6
2
0
2(S
0
)S
0
_
c a(2b + 1)H(S
0
, )
__
|a(2b + 1)|
_
,
(4.2)
If b >
1
2
, we calibrate the parameters to the displaced Heston model; if b <
1
2
, we calibrate
the parameters to the displaced anti -Heston model. For the singular case b =
1
2
, we take
the same approach as in the DL case.
Compared with the calibration of the DL parameters given in (4.1), we see that the is
the same in both the DL and the DH case. In the DL case, we have = a(2b + 1); while in
the DH case, we have
0
= |a(2b + 1)|.
Remark 4.1.2. Although (3.14) and (3.21) are short-expiry limit, Remark 3.2.1 indicates
their accuracy at T of moderate length. Therefore (4.2) may still facilitate calibration of
(
0
, , , , , ) to volatility skews (a, b, c) even at moderately long expiries.
4.2 Calibration DL and DH to CEV/SABR
4.2.1 CEV and SABR stochastic volatility models
For many local or stochastic volatility models, there exist explicit short maturity approxi-
mations of implied volatility, such as in Lewis (2000) and Berestycki et al. (2004), making it
easy to calculate the implied volatility level a, slope b and convexity c, and to calibrate DL
parameters and via (4.1), or to calibrate DH parameters (
0
, , , , , ) via (4.2).
Two such models capable of generating realistically steep at-the-money implied volatility
skews are the Constant Elasticity of Variance (CEV) model and the SABR model. In the
23
CEV model (Cox 1996),
dS
t
= S
t
dW
t
, S
0
> 0, (4.3)
where 1, and absorption is imposed at S = 0.
Remark 4.2.1. Boundary Conditions for the CEV:
< 1/2: 0 is attainable. The origin is a regular boundary point and is specied as a
killing boundary by adjoining a killing boundary condition.
= 1/2: 0 is attainable and strong reecting.
> 1/2: 0 is not attainable. 0 is exist boundary.
The CEV model can generate a steep downward implied volatility skew at-the-money.
Indeed, by Berestycki et al. (2002) and Roper (2009), for all K > 0,
lim
T0
CEV
imp
(K, T) =
_
_
(1 ) log(S
0
/K)
S
1
0
K
1
if K = S
0
S
1
0
if K = S
0
.
(4.4)
Dierentiating with respect to log K, we have
log
CEV
imp
log K
T0, K=S
0
=
1
2
, (4.5)
which can take arbitrarily large negative values.
The widely-used SABR model (Hagan et al. 2002) generalizes the CEV, by making
the coecient stochastic, with volatility-of-volatility 0, and correlation [1, 1]
between S and :
dS
t
=
t
S
t
dW
t
, S
0
> 0
d
t
=
t
dB
t
,
0
> 0
dB
t
= dW
t
+
_
1
2
dW
t
(4.6)
where W and W
are independent Brownian motions, and absorption is imposed at S = 0.

Taking = 0 in the SABR model reduces to the CEV case.
24
According to a short-expiry approximation in Hagan et al. (2002, eq. 3.1a),
SABR
imp
(K, T)
0
S
1
0
_
1 +
_
1
2
+

2S
1
0
_
log(K/S
0
)
_
. (4.7)
The approximations slope at K = S
0
is
log
SABR
imp
log K
T0, K=S
0
1
2
+

2S
1
0
, (4.8)
reecting the contributions to the SABR volatility skew, not just from the functional rela-
tionship between price levels and volatility, as expressed by , but also from the correlation
between price increments and volatility, as expressed by .
4.2.2 Calibration of DL to CEV/SABR
For the SABR process, a =
0
S
1
0
, and b is given by (4.8), so we have
=
0
S
1
0
+ , = S
0

0
S
0
S
1
0
+
. (4.9)
The = 0 special case of (4.9) gives the DL parameters that match the CEV level and slope:
= S
1
0
, = S
0
( 1)/. (4.10)
In the CEV case, Marris (1999) and Svoboda-Greenwood (2009) have already investigated
displaced lognormal approximation, by an approach which chooses parameters such that the
displaced lognormal instantaneous volatility approximates the CEV instantaneous volatility
function S S
, in contrast to our approach which matches the implied volatility functions.

Their approach arrived at the same result (4.10) as our approach, in the CEV case.
A distinction is that our implied volatility approach is intended to apply moreover to
models, such as SABR, where instantaneous volatility varies not just as a function of S, but
also other stochastic factors. The implied volatility skew reects the dependence of volatility
on the S level together with the other stochastic factors in the model, such as in the SABR
case.
25
4.2.3 Calibration of DH to SABR
Durrleman (2004) shows that (3.13) can also be used as an approximation for the short-expiry
implied volatility of SABR model (4.6) with
0
=
0
S
1
0
, a
0
= ( + ( 1)
0
)
0
,
c
0
=

2
6
(4 3
2
) + ( 1)
0
+
5
6
( 1)
2
2
0
,
b
0
=

2
0
6
(
2
(2 3
2
) + 6
0
+ ( 1)
2
2
0
).
(4.11)
From this, we derive the approximation of the short-expiry SABR implied volatility level,
slope and convexity as follows.
a(T) =
_
2
0
+ b
0
T
2
,
b(T) =
(
atm
)
2
a
0
2
,
c(T) =
(
atm
)
2
a
0
2K
atm
K
+
a
0
+ c
0
2K
2
(
atm
)
1
,
(4.12)
where
atm
is approximated by (3.13) with K = S
0
. The parameters of DH are chosen by
plugging (4.12) into (4.2).
Remark 4.2.2. In (4.12), lim
T0
a(T) = S
1
0
, lim
T0
b(T) =
1
2
+

2S
1
0
, the same
as the level and slope given in (4.7) and (4.8).
26
CHAPTER 5
VARIANCE REDUCTION IN MONTE CARLO SIMULATION
5.1 Variance Reduction Using Control Variate
Theorems 1 and 2 imply that the displaced lognormal is inconsistent with the steep downward
slopes (Remark 2.2.2) and non-monotonicity (Remark 2.2.1) typical of stock market volatility
skews. The displaced anti -lognormal, by (2.24), overcomes the steepness constraint, but
introduces other drawbacks: its paths, which take values in (, ), are bounded above and
unbounded below the opposite of the behavior desirable in a model of stock prices. Such
paradox applies to the DH process too. Proposition 3.1.2 implies that the displaced Heston
is inconsistent with the steep downward slopes (Remark 3.1.2). The displaced anti -Heston
overcomes the steepness constraint but its paths are unbounded from below.
For these reasons, we do not generally advocate the DL/DH to model stock price pro-
cesses. Rather, we propose the DL/DH to generate control variates to reduce variance in
the Monte Carlo pricing of derivative contracts under commonly-used dynamics which do
match the empirical at-the-money volatility skew.
Indeed, suppose the underlying S dynamics follow some specication that a modeler
deems appropriate, such as the CEV or the SABR stochastic volatility model. Suppose the
modeler intends to price a derivative contract for which the desired model lacks analytical
pricing formulas, such as a discretely-monitored barrier option on the CEV/SABR process
S. Let the contracts payo Y be given by a specied function of the S path. In the absence
of analytical solutions, consider the use of Monte Carlo simulation to estimate the price EY.
The basic Monte Carlo estimator is the sample average
C :=
1
M
m
Y
m
(5.1)
where the simulations Y
1
, . . . Y
M
are iid as Y. To improve accuracy, in the sense of reducing
variance, let us apply the control variate technique, where the control comes from a DL
process calibrated by (4.1), or from a DH process calibrated by (4.2).
27
There exist, of course, other variance reduction methods, combinable with a DL/DH
control variate. We do not investigate them in this section; rather we maintain focus on
the DL/DH control, with the intent of illustrating how much variance reduction the DL/DH
control brings by itself. In section 5.2 we will discuss combining the DL/DH control with
other techniques.
5.1.1 DL or DH as a control variate
To make explanation clear, we rst focuses on using DL as control variate. Using DH as
control variate follows the same spirit.
The control variate estimator of EY, using a control Y , where Y has a known expectation
C := EY and a known simulation methodology, is dened by
C
cv
:=
1
M
m
_
Y
m
Y
m
+ C
_
, (5.2)
where the simulated pairs (Y
1
, Y
1
), . . . , (Y
M
, Y
M
) are iid as (Y, Y ). Good choices of Y have
large correlation
Y,Y
with Y, because increasing |
Y,Y
| decreases the estimators variance.
Specically,
Var

C
cv
= (1
2
Y,Y
) Var

C (5.3)
for the optimal choice of the coecient, namely = Cov(Y, Y )/ Var(Y ), which may also
be estimated by simulation. For further details see, for instance, Boyle et al. (1997).
Because the payo Y is a specied function of the S path, we choose Y to be that same
payo function applied to the S path, where S follows a DL process driven by a Brownian
motion that also drives S. Aiming to produce high correlation
Y,Y
, we choose the S process
parameters by taking S
0
= S
0
and applying (4.1) to nd (, ) such that the short-expiry
at-the-money volatility skews implied by S and by S agree in both level and slope.
The suitability of the DL process S to serve in this role stems from a conuence of
exibility and tractability; the DL is potentially exible enough to generate signicant cor-
relation between Y and Y (by linking the parameters of S and S, as discussed above), and
yet potentially tractable enough to allow analytic evaluation of EY and unbiased simulation
of Y , as discussed below.
For shift-invariant contracts (including barriers and lookbacks), exact evaluation of C =
EY under DL dynamics is just as easy as under Black-Scholes dynamics; more precisely,
28
if the contracts payo is invariant to parallel shifts of the underlying price path and the
contract parameters (such as strike and barrier level), then Black-Scholes model valuation
methods, applied to shifted arguments, produce the contracts DL valuation. In the DL case,
if, moreover, we can simulate the exact distribution of Y which is often the case, because
S is a transformed Gaussian then Y can serve as a control variate that reduces variance
without introducing any bias.
When using DH as control variate, we have one more source of exibility, namely the
stochastic volatility process. If Y depends on the path S where S depends on a stochastic
volatility process , S is driven by a Brownian motion W and is driven by W and W
,
where W and W
are independent, we choose Y to be the same payo function applied to

the S path, where S follows a DH process driven by W, and the volatility process of S is
driven by W
. We choose the S process parameters by taking S

0
= S
0
and applying (4.2)
to nd (
0
, , , , , ) such that the short-expiry at-the-money volatility skews implied by
S and by S agree in level, slope and convexity.
The DH control variate has an advantage over the DL control variate in that the DH
model is more exible and the S path tracks the S path more closely. Consequently, Y will
have higher correlation with Y so we can achieve greater variance reduction. On the other
hand, the option pricing formula on the DH model is more complicated than on the DL
model.
5.1.2 Example I: Discretely sampled barrier option under CEV/SABR
dynamics
To take a concrete example, consider a discretely sampled barrier option on S, which follows
CEV (4.3) or SABR (4.6) dynamics. In particular, let the contract be a down-and-out call
with expiry T, barrier H, strike K, sampling dates t
1
< t
2
< < T
N
= T, and payo
Y := (S
T
K)
+
1(min
n
S
t
n
> H). (5.4)
Analytical solutions exist for continuous barriers in the CEV model (Davydov-Linetsky
2001), but not for discrete barriers, nor for the SABR model, so we turn to Monte Carlo
simulation.
29
DL as control variate
To generate a control variate on DL, we apply the same payo function to a DL process,
driven by the same Brownian motion W = W. More precisely,
Y := (S
T
K)
+
1(min
n
S
t
n
> H)
dS
t
= (S
t
)dW
t
,
(5.5)
where S
0
= S
0
, and (, ) are calibrated by (4.9) in the SABR case, or (4.10) in the CEV
case.
In the DL case, This Y is easily simulated without bias, and the value of C = EY can
be computed by shifting any of the fast and exact (up to numerical truncation/quadrature
error) solutions for discrete barrier option prices in the Gaussian framework, such as Broadie
and Yamamoto (2005), or in the Levy framework, such as Petrella and Kou (2004) or Feng
and Linetsky (2008).
An alternative to (5.5) is to choose instead a continuously-monitored control
Y
:= (S
T
K)
+
1( min
t[0,T]
S
t
> H). (5.6)
The control expectation EY
has a simple exact formula, and the control Y
can be simulated
without bias, using Brownian bridge techniques of Beaglehole et al. (1997).
DH as control variate
To generate a control variate on DH, we apply the same payo function to a DH process,
driven by the same Brownian motion W = W, W
= W
. The DH process parameters

(
0
, , , , , ) are calibrated by (4.2) where a, b, c are determined by (4.12). More precisely,
if b >
1
2
, the control variate is based on the displaced Heston model,
Y := (S
T
K)
+
1(min
n
S
t
n
> H)
dS
t
=
t
(S
t
)dW
t
, S
0
> ,
d
2
t
= (
2
t
)dt +
t
dW
t
, dW
t
dW
t
= 0
(5.7)
30
If b <
1
2
, the control variate is based on displaced anti -Heston model:
Y := (S
T
K)
+
1(min
n
S
t
n
> H)
dS
t
= (
t
)(S
t
)dW
t
, 0 < S
0
< ,
d
2
t
= (
2
t
)dt +
t
dW
t
, dW
t
dW
t
= 0
(5.8)
In both (5.7) and (5.8), S
0
= S
0
and
t
In the DH case, the Y can be simulated from an ecient discretisation scheme which
guarantees strong convergence, such as Lord et, al (2006). We discuss this more in detail in
Chapter 6. The value of C = EY can be computed by shifting any of the fast solutions for
discrete barrier option price under the Heston model, such as Griebsch and Wystup (2008).
5.1.3 Numerical results I: Discretely sampled barrier option under
CEV/SABR dynamics
DL as Control Variate
Our experiments simulate the payo (5.4), where
K = S
0
= 100, H = 95, T = 4/12, N = 84. (5.9)
In the CEV case we take {0.5, 1.0, 1.5}, with such that S
1
0
{0.15, 0.20, 0.25},
based on Hirsa-Courtadon-Madans (2003) estimates of S&P500 CEV parameters; our is
what they denote as + 1. We use the control (5.5), where (, ) are tuned to the CEV by
(4.10).
In the SABR case we take = 0.2, with
0
such that
0
S
1
0
= 0.2, with an array of
choices for (, ). We use the control (5.5), where (, ) are tuned to the SABR by (4.9).
We run 1000 paths. Ten equal spaced points are sampled each day. Tables 5.1.1 and
5.1.2 report the estimated percentage reduction of variance
100%
Var(

C
cv
)
Var(

C)
, (5.10)
31
Table 5.1.1: Percentage reduction of variance, using DL for down-and-out call on CEV
T = 4 months
S
1
0
0.15 0.20 0.25
-0.50 99.99% 99.99% 99.99%
-1.00 99.99% 99.98% 99.93%
-1.50 99.98% 99.89% 98.67%
Payo: (5.4) with (5.9). Control: (5.5) with (4.10).
Table 5.1.2: Percentage reduction of variance, using DL for down-and-out call on SABR
T = 4 months

0.20 0.40 0.60
-0.4 98.74% 96.07% 92.42%
-0.6 98.83% 97.17% 93.70%
-0.8 99.64% 98.71% 96.76%
Payo: (5.4) with (5.9). Control: (5.5) with (4.9).
where each

Var is the scaled sample variance of the summands in (5.1) and (5.2) respec-
tively. Equivalently, the percentage reduction of variance equals the R-squared of an OLS
regression of the CEV/SABR barrier-option payo Y on the DL control payo Y .
DH as Control Variate
Our next experiments simulate the payo (5.4) with parameters given by (5.9), using DH
as control variate for the down-and-out discrete barrier under the SABR process. The
parameters of the SABR process are = 0.2, with
0
such that
0
S
1
0
= 0.2, with an
Table 5.1.3: Percentage reduction of variance, using DH for down-and-out call on SABR
T = 4 months

0.20 0.40 0.60
-0.4 99.76% 99.03% 99.41%
-0.6 99.73% 98.95% 99.35%
-0.8 99.00% 98.60% 98.73%
Payo: (5.4) with (5.9). Control: (5.7) with (4.2) or (5.8) with (4.2).
In (4.2), a, b and c are calculated from (4.12).
32
array of choices for (, ). The results are shown in Table 5.1.3.
Comparing the results in Table 5.1.2 and 5.1.3, we can see that using DH as control
variate achieves more variance reduction. As we noted before, the reason is that the DH
process is a two-factor stochastic dynamics which enable the process S to better track the
original process, S.
Remark 5.1.1. In the reported Table 5.1.3 and any other reported results related to DH
process in this paper, we arbitrarily chose = 0.2. Numerical simulations suggest that other
choices of give relatively same results.
5.1.4 Example II: Discretely sampled arithmetic Asian option under
SABR dynamics
The next example we consider is the discretely sampled arithmetic Asian option on S, which
follows the SABR dynamics (4.6). Let the contract be an Asian call option with expiry T,
strike K, sampling dates t
1
< t
2
< < t
N
= T, and payo
Y := (
1
N
N
i=1
S
i
K)
+
(5.11)
There is no analytical solution for the arithmetic Asian option price under the SABR process,
so we turn to Monte Carlo simulation.
DL as control variate
For the control variate, we could apply the same payo to the DL process. Although there
is no exact analytical solution for the value of the discrete arithmetic Asian option under
the DL process, it could be computed by shifting the numerical solution for the discrete
arithmetic Asian option under Geometric Brownian motion, such as Milevsky and Posner
(1998), Fusai and Meucci (2008).
Here we consider a slightly dierent payo which we know how to compute exactly under
the DL process. We call the new payo discrete exponential Asian option. The DL process
is driven by the same Brownian motion which drive the SABR process, W = W. More
33
precisely, the control is,
Y
:=
_
_
_
( + exp(
1
N
N
i=1
log(S
i
)) K)
+
if displaced lognormal is used
( exp(
1
N
N
i=1
log( S
i
)) K)
+
if displaced anti -lognormal is used
dS
t
= (S
t
)dW
t
(5.12)
The value C
= EY
can be calculated analytically under the DL process.

Lognormal as control variate
To make a comparison, we also use the control variate under the lognormal(LN) process.
The control variate is constructed by applying the discrete exponential Asian option to the
lognormal process, driven by the same Brownian motion W = W. More precisely,
Y
:= (exp(
1
N
N
i=1
log(S
i
)) K)
+
dS
t
=
LN
S
t
dW
t
(5.13)
The value C
= EY
can be calculated analytically. In (5.13), we choose

LN
to be the
short-expiry at-the-money implied volatility of the SABR process, which is
LN
=
0
S
1
0
. (5.14)
5.1.5 Numerical results II: Discretely sampled arithmetic Asian option
under SABR dynamics
Our experiments simulate the payo (5.11), where
K = S
0
= 100, T = 4/12, N = 84, = 0.2,
0
S
1
0
= 0.2 (5.15)
and an array of choices for (, ). We use control (5.12) where (, ) are tuned to SABR by
(4.9). We also report variance reduction results using control (5.13) with parameters (5.14).
We run 1000 paths. Ten equal spaced points are sampled each day. Table 5.1.4 and 5.1.5
report the estimated percentage reduction of variance. The results suggest that the DL
control achieves signicantly larger variance reduction than the LN control.
34
Table 5.1.4: Percentage reduction of variance, using DL as control for Asian Option on
SABR
T = 4 months

0.20 0.40 0.60
-0.4 99.57% 98.43% 96.19%
-0.6 99.69% 98.74% 97.36%
-0.8 99.83% 99.24% 98.21%
Payo: (5.11) with (5.15). Exponential Asian option on DL control: (5.12) with (4.9).
Table 5.1.5: Percentage reduction of variance, using LN as control for Asian Option on SABR
T = 4 months

0.20 0.40 0.60
-0.4 75.34% 78.61% 76.06%
-0.6 76.61% 77.97% 78.95%
-0.8 78.96% 80.76% 79.18%
Payo: (5.11) with (5.15). Exponential Asian option on LN control: (5.13) with (5.14).
5.2 Variance Reduction Combining Control Variate and
Importance Sampling
In this section, we study the issue of combining the importance sampling with the control
variate. Importance sampling itself is a popular variance reduction technique, see Bolye,
Broadie and Glasserman (1997) for more details.
5.2.1 Importance sampling on options pricing
Recall the SABR process in (4.6), if we dene
d

W
t
:= dW
t
a
t
dt,
then by the Girsanov Theorem, there is a measure

P such that under which

W
t
, W
t
are
independent standard Brownian motions, and W
t
is a drifted Brownian motion. Under

P,
35
the original process S becomes a drifted SABR process:
dS
t
=
t
S
t
(d

W
t
+ a
t
dt), S
0
> 0
d
t
=
t
dB
t
,
0
> 0
dB
t
= d

W
t
+
_
1
2
dW
t
(5.16)
Again by the Girsanov Theorem, the likelihood ratio or Radon-Nikodym derivative be-
tween the original measure P and the new measure

P is
r(S) :=
dP
d
P
= exp
_
_
T
0
a
s
dW
s
+
1
2
_
T
0
a
2
s
ds
_
. (5.17)
For any function G(.) : C R, where C is the domain of S, the Girsanov Theorem says
EG(S) =

Er(S)G(S), (5.18)
where

E is the expectation which is taken under

P. Therefore, the importance sampling
estimator (IS-estimator) is:
C
IS
:=
1
M
m
r(S
m
)G(S
m
). (5.19)
r(S
m
)G(S
m
) can be considered as a weighted payo.
The drift a
t
is chosen in a heuristic way similar to Bolye et al (1997). Denote
a
0
=
_
| log(S/K)| +| log(K/H)|
_
/T +
1
2
2
0
S
22
0
0
S
1
0
. (5.20)
We would like to control the variance of the likelihood ratio, which is exp(
_
T
0
a
2
s
ds), so that
it does not explode in real applications. We will arbitrarily set a constant C
a
< and
set a
0
= min(C
a
, a
0
). Next, for the down-and-out call options, we choose a
t
= a
0
; for the
down-and-in call options, we choose a
t
= a
0
before the barrier is reached and a
t
= a
0
after
the barrier is reached. The intuition behind this is to make the path less(more) likely to
reach the barrier in the down-and-out(down-and-in) case.
36
5.2.2 Drifted DH/DL process
The drifted DH/DL dynamics is derived similarly as the drifted SABR dynamics. Recall that
if we dene d

W
t
:= dW
t
a
t
dt, then under the new measure

P,

W
t
and W
t
are independent
standard Brownian motions. Consequently, the DL dynamics dened in (2.6) and (2.15),
DH dynamics dened in (3.1) and (3.16) become drifted DL/DH processes under the new
measure

P. These drifted processes are listed below.
Under

P, the displaced lognormal dynamics becomes the drifted displaced lognormal dy-
namics:
dS
t
= (S
t
)(d

W
t
+ a
t
dt), S
0
> , > 0. (5.21)
The drifted displaced anti-lognormal dynamics is
dS
t
= (S
t
)(d

W
t
+ a
t
dt), 0 < S
0
< , < 0. (5.22)
The drifted displaced Heston dynamics is
dS
t
=
t
(S
t
)(d

W
1t
+ a
t
dt), S
0
>
d
2
t
= (
2
t
)dt +
t
dB
t
,
dB
t
= dW
t
+
_
1
2
dW
t
.
(5.23)
The drifted displaced anti-Heston dynamics is
dS
t
= (
t
)(S
t
)(d

W
1t
+ a
t
dt), 0 < S
0
<
d
2
t
= (
2
t
)dt +
t
dB
t
,
dB
t
= dW
t
+
_
1
2
dW
t
.
(5.24)
In both the drifted displaced Heston model and the drifted displaced anti -Heston model,
t
5.2.3 Combine control variate with importance sampling
Since the IS-estimator

C
IS
has smaller variance than the naive estimator

C, we can construct
a control variate for the IS-estimator. We call the new estimator ISCV-estimator, and denote
it as

C
ISCV
.

C
ISCV
will reduce variance further than

C
IS
.
37
The detail of the ISCV-estimator is as follows. First, considering the weighted payo in
(5.19) as one payo function on S:
Y = H(S) := r(S)G(S), (5.25)
where S is sampled from (5.16). As in section 5.1.2, we want to choose a control variate Y
that is highly correlated with Y. Y is constructed by applying the new payo function H(.)
onto the drifted DL/DH process S:
Y := H(S) = r(S)G(S). (5.26)
It turns out that H(S) = r(S)G(S) can also be considered as an IS-estimator for the non-
drifted DL/DH process S, because by the Girsanov Theorem,
EG(S) =

Er(S)G(S). (5.27)
Finally, we propose the combined estimator of the importance sampling and the control
variate as follows.
C
ISCV
=
1
M
m
r(S
m
)G(S
m
)
_
1
M
m
r(S
m
)G(S
m
) EG(S)
_
. (5.28)
where S
i
is sampled from (5.16), and S
i
is sampled from any of the drifted DL/DH process
(5.21)-(5.24).
Remark 5.2.1. This estimator coincides with the estimator proposed by Hesterberg (1996),
but comes from a dierent angle. In Hesterbergs approach, both the importance sampling
estimator and the control variate estimator are regarded as weighted sums and are com-
bined together as a double weighted sum. Our approach is to nd a control variate for the
importance sampling estimator.
5.2.4 Example: Discretely sampled barrier option under SABR dynamics
We consider a discretely sampled barrier option on S, which follows the SABR (4.6) dynamics.
In particular, let the contract be a down-and-in call with expiry T, barrier H, strike K,
38
sampling dates t
1
< t
2
< < t
N
= T, and payo:
G(S) := (S
T
K)
+
1( min
1nN
S
t
n
< H). (5.29)
To construct the

C
ISCV
, we apply the payo function G(.) to a drifted DL/DH process S,
where S is driven by the Brownian motion W = W. If using DH, the volatility of S is driven
by W
= W
. in the DL case, (, ) are tuned by (4.9); in the DH case, (

0
, , , , , ) are
tuned by (4.2) where a, b, c are determined by (4.12).
In practice, there is no way of exactly sampling from the continuous SABR process and
the correlated DH process, so discretisation schemes are used. We discretize the SABR
process into I subintervals and sample discretely. The discretisation of the SABR process is:
log S
i+1
= log S
i

2
i
2
S
22
i
t +
i
S
1
i
W
i
log
i+1
= log
i

2
2
t + ((W
i
E(W
i
)) +
_
1
2
W
i
)
(5.30)
where W
i
, W
i
i.i.d. N(0, t), i = 1, , I. To sample from the drifted SABR process,
we take W
i
N(a
i
t, t) in (5.30). a
i
is chosen by the rule at the end of section 5.2.1.
The likelihood-ratio is calculated as
r(S) =
I
i=1
f(W
i
)
f
(W
i
)
= exp(
I
i=1
a
i
W
i
+
1
2
I
i=1
a
2
i
t). (5.31)
where f(.) is the density function of N(0, t) and f
(.) is the density function of N(a

i
t, t).
To construct ISCV with DL control, we sample from the drifted DL process and apply
the payo G(.) to it:
G(S) := (S
T
K)
+
1( min
1nN
S
t
n
< H),
log(S
i+1
) = log(S
i
)

2
2
t + W
i
, if b >
1
2
log( S
i+1
) = log( S
i
)

2
2
t + W
i
, if b <
1
2
(5.32)
where S
0
= S
0
, W = W N(a
i
t, t). We are not showing the degenerate case where
b =
1
2
and S
i
is sampled from a geometric Brownian motion.
39
Similarly, to construct ISCV with DH control, we sample from the drifted DH process
and apply the same payo G(.) to it:
G(S) := (S
T
K)
+
1( min
1nN
S
t
n
< H),
log(S
i+1
) = log(S
i
)

2
i
2
t +|
i
|W
i
, if b >
1
2
log( S
i+1
) = log( S
i
)

2
i
2
t |
i
|W
i
, if b <
1
2
2
i+1
=
2
i
+ (
2
i
)t +
_
|
2
i
|((W
i
E(W
i
)) +
_
1
2
W
i
),
(5.33)
where S
0
= S
0
, W = W N(a
i
t, t), W
= W
N(0, t), and

t
is non-negative for
all t > 0.
Remark 5.2.2. The volatility process of DH is a mean-reverting square process. There are
various discretisation schemes, see Lord et al (2008) for more detail. We choose the rst
order Euler discretisation scheme with reection principal proposed by Higham and Mao
(2005), where the partial strong convergence of S
i
is ensured. More discussion of this is in
Chapter 6.
The likelihood ratio in both (5.32) and (5.33) is the same as in (5.31):
r(S) = exp(
I
i=1
a
i
W
i
+
1
2
I
i=1
a
2
i
t) (5.34)
Finally, the ISCV-estimator is constructed as
C
ISCV
=
1
M
m
_
G(S
m
)r(S
m
) G(S
m
)r(S
m
) + EG(S
m
)
_
. (5.35)
5.2.5 Numerical results: Discretely sampled barrier option
In this section, we compare the variance reduction of the importance sampling, with that of
combining importance sampling with the control variate. Denote ISDL to be the estimator
which combines the importance sampling and DL control variate from (5.32) as in (5.35).
Denote ISDH to be the estimator which combines the importance sampling and the DH
control variate from (5.33) as in (5.35).
40
The experiments simulate the payos (5.4) and (5.29), where
K = S
0
= 100, H = 95, T = 4/12, N = 84, = 0.2,
0
S
1
0
= 0.2. (5.36)
We simulate 1000 pathes. For the DH parameters in ISDH, prex = 0, = 0.2. Table 5.2.1
and 5.2.2 show the variance reduction of the down-and-out call options using importance
sampling, ISDL and ISDH. Table 5.2.3 and 5.2.4 show the variance reduction of the down-
and-in call options using the three estimators. For both options, we see that ISDL and ISDH
achieve more variance reduction than importance sampling.
Table 5.2.1: Percentage reduction of variance, using importance sampling for down-and-out
call on SABR
T = 4 months, Importance Sampling

0.20 0.40 0.60
-0.4 69.46% 68.32% 67.00%
-0.6 69.07% 67.70% 66.26%
-0.8 68.77% 67.31% 65.69%
Payo: (5.4) with (5.36).
Table 5.2.2: Percentage reduction of variance, using ISDL and ISDH for down-and-out call
on SABR
T = 4 months, ISDL

0.20 0.40 0.60
-0.4 97.02% 89.99% 83.31%
-0.6 97.32% 90.91% 85.71%
-0.8 97.48% 94.55% 89.30%
T = 4 months, ISDH

0.20 0.40 0.60
-0.4 98.16% 98.87% 97.20%
-0.6 97.91% 97.34% 96.87%
-0.8 97.69% 95.55% 96.45%
Payo: (5.4) with (5.36).
ISDL: Combined importance sampling and DL control variate: (5.32) and (5.35). Parameters
of DL: (4.9).
ISDH: Combined importance sampling and DH control variate: (5.33) and (5.35). Parame-
ters of DH: (4.2).
41
Table 5.2.3: Percentage reduction of variance, using importance sampling for down-and-in
call on SABR
T = 4 months, Importance Sampling

0.20 0.40 0.60
-0.4 33.71% 32.35% 32.13%
-0.6 35.85% 33.09% 30.97%
-0.8 35.95% 33.25% 32.10%
Payo: (5.29) with (5.36).
Table 5.2.4: Percentage reduction of variance, using ISDL and ISDH for down-and-in call on
SABR
T = 4 months, ISDL

0.20 0.40 0.60
-0.4 96.06% 87.59% 79.68%
-0.6 96.58% 88.80% 82.50%
-0.8 96.77% 93.42% 87.49%
T = 4 months, ISDH

0.20 0.40 0.60
-0.4 97.89% 98.75% 95.96%
-0.6 97.36% 97.00% 94.46%
-0.8 97.06% 94.01% 94.63%
Payo: (5.29) with (5.36).
ISDL: Combined importance sampling and DL control variate: (5.32) and (5.35). Parameters
of DL: (4.9).
ISDH: Combined importance sampling and DH control variate: (5.33) and (5.35). Parame-
ters of DH: (4.2).
We summarize the discussion of this Chapter here. As mentioned by Fisher and Tataru
(2010), the stochastic/local volatility (SLV) model has become market standard for barrier
option pricing. The CEV/SABR model belongs to the family of SLV models, so pricing
barrier options under them is of practical interest. This section uses DL and DH as control
variate to reduce variance in the Monte Carlo simulation of the barrier options. More
specically, we give numerical examples to demonstrate that the DL and DH controls can
provide signicant variance reduction for barrier option pricing under the CEV/SABR model,
as shown in Tables 5.1.1, 5.1.2 and 5.1.3. Moreover, we show that DL/DH in concert with
importance sampling is superior to the importance sampling alone, by comparing Table 5.2.1
with 5.2.2, as well as Table 5.2.3 with 5.2.4. Finally, we show that the DL controls also yield
signicant variance reduction for Asian options.
42
CHAPTER 6
DISCRETISATION SCHEME
For most general stochastic processes, exact simulation methods do not exist and we have
to refer to discretisation schemes to simulate them. There are three basic criteria in the
discretisation schemes: rate of convergence, stability and positivity. These criteria have been
widely and intensively discussed in the literature. For more detail, see Lord et al (2008),
Kahl (2004), Zhang et al (2004) and Higham and Mao (2005). We use some discretisation
schemes in section 5.2.5 and this chapter we will validate their usage.
There are many numerical schemes. Euler-Maruyama (Euler for short) scheme is a
straightforward discretisation scheme, wherein one discretises the time interval of interest,
and simulates the process at the discretisation points. Under certain conditions, it can be
shown that the Euler scheme converges to the true process as the time intervals are made
ner and ner. Sometimes, in order to reserve the positivity of the underlying process, the
Log-Euler scheme is used, where one simulates from the discretisation of the logarithm of
the original process.
Consider a stochastic process:
dS
t
= A(t, S
t
)dt + B(t, S
t
)dW
t
, (6.1)
where W
t
is Brownian motion. Denote the discrete approximation of the process as S
t
t
.
Most existing proofs of the convergence of S
t
t
to S
t
rely on the linear growth and global
Lipschitz conditions (Kloeden and Platen (1992)):
(linear growth) there exists a positive constant L
1
such that
|B(t, x)|
2
L
1
(1 + x
2
); (6.2)
(global Lipschitz ) there exists a positive constant L
2
such that
|B(t, x) B(t, y)|
2
L
2
|x y|
2
. (6.3)
43
However, for the CEV/SABR processes, the strong convergence rule shown in Kloeden
and Platen (1992) can not be applied since S
t
does not satisfy the global Lipschitz condition.
Zhang et al (2004) relax the condition of the convergence to local Lipschitz. For the process
(6.1), they show that its Euler discretisation converges to the underlying continuous process
in L
2
sense before a stopping time, if S
t
satises a local Lipschitz condition before the
stopping time. Since the convergence they prove is up to a stopping time, we refer to it
as partial strong convergence. The result can be extended to the Log-Euler discretisation:
if the logarithm of the underlying process satises the local Lipschitz condition before the
stopping time, then the Log-Euler discretisation converges to the logarithm of the underlying
process. We extend the result further to a stochastic volatility case, where A(.), B(.) could
depend on a stochastic volatility process
t
. This result serves as the theoretical foundation
of the Monte Carlo simulation of the CEV/SABR process.
6.1 Partial Strong Convergency of Stochastic Volatility Process
Consider the stochastic process
dS
t
= A(t, S
t
,
t
)dt + B(t, S
t
,
t
)dW
1t
, (6.4)
d
t
= C(
t
)dW
2t
, dW
1t
dW
2t
= dt (6.5)
Approximate S
t
,
t
using Euler scheme on time points t
n
= nt, where n = 1, ...N, and
Nt = T. The discretisation scheme is given as
S
t
t+t
= S
t
t
+ A(t, S
t
t
,
t
t
)t + B(t, S
t
t
,
t
t
)W
1,t
,
t
t+t
= f(
t
t
, t, W
2,t
),
(6.6)
where W
i,t
= W
i,t+t
W
i,t
, i = 1, 2.
Remark 6.1.1. We do not specify the discretisation scheme of
t
here. It could be any
reasonable discretisation scheme, for example, the Euler scheme as:
t
t+t
=
t
t
+ C(
t
t
)W
2,t
; (6.7)
44
or the Log-Euler scheme as:
t
t+t
=
t
t
exp
_
C(
t
t
)
t
t
W
2,t
1
2
_
C(
t
t
)
t
t
_
2
t
_
. (6.8)
For the SABR process, the
t
can be simulated exactly using the Log-Euler scheme.
Dene the local Lipschitz condition (*) as follows: let
1
,
2
be compact sets, there exist
positive constants K
1
(
1
2
) and K
2
(
1
2
), such that for any x
1
, x
2

1
, z
1
, z
2

2
,
|A(t, x
1
, z
1
)A(t, x
2
, z
2
)|
2
|B(t, x
1
, z
1
)B(t, x
2
, z
2
)|
2
K
1
(
1
2
)|x
1
x
2
|
2
+K
2
(
1
2
)|z
1
z
2
|
2
.
(6.9)
If local Lipschitz condition (*) holds, then for the bounded
1
,
2
, there exists a positive
constant K
3
(
1
2
), such that for all x
1
, z
2
,
|A(t, x, z)|
2
|B(t, x, z)|
2
K
3
(
1
2
). (6.10)
Theorem 12 says that under the local Lipschitz condition (*) and some other regularity
conditions, the discretized process S
t
t
will have L
2
convergency to the true process S before
a stopping time.
Theorem 12. Let
1
,
2
be bounded regions and denote the stopping time
= inf{t 0 : S
t
t
/
1
or S
t
/
1
or
t
/
2
}.
For discretisation scheme in (6.6), if the following conditions are satised:
i. A(t, S
t
,
t
) and B(t, S
t
,
t
) satisfy the local Lipschitz condition (*);
ii. for t small enough and t [t
n
, t
n+1
), there is a constant D(
2
) such that
E(
t
t
t
n
)
2
D(
2
)t; (6.11)
then for tT < 1, constant C(
1
2
), such that
E
_
sup
0tT
|S
t
t
S
t
|
2
_
C(
1
2
)t. (6.12)
45
In other words, as long as S
t
t
and S
t
remain in the domain
1
and
t
remains in the
domain
2
, the Euler scheme S
t
t
converges to the true process S
t
as t 0.
Proof. Appendix C.1.
Remark 6.1.2. If
t
follows the geometric Brownian motion such that
t
=
t
dW
t
, then
t
t
n
can be simulated exactly as
t
n
. Since
t
=
t
n
e
sX
1
2
s
2
where s = t t
n
and
X N(0, 1), substitute
t
t
with
t
n
, and we have
E(
t
t
t
n
)
2
= E(
t
n
)
2
(e
s
2
1) = e
t
n
2
(e
s
2
1).
Since s < t, for any t
n
< T and small enough t, there is a constant K such that
e
t
n
2
(e
s
2
1) < Kt. Therefore
t
,
t
t
satisfy the condition (ii) in Theorem 12.
Remark 6.1.3. In the SABR process, we have A(t, S
t
,
t
) = 0 and B(t, S
t
,
t
) =
t
S
t
. In the
logarithm of the SABR process, we have A(t, S
t
,
t
) =
1
2
2
t
S
22
t
and B(t, S
t
,
t
) =
t
S
1
t
.
In both cases, A(.) and B(.) satisfy the local Lipschitz condition (*). (see appendix C.2
for detail.) So, Theorem 12 indicates that the Euler (Log-Euler) discretisation scheme of
the SABR process (with
t
simulated exactly) will converge to the true process on the time
interval T, where = inf{t 0 : S
t
t
/ [a
1
, a
2
] or S
t
/ [a
1
, a
2
] or
t
/ [b
1
, b
2
]; 0 < a
1
<
a
2
, 0 < b
1
< b
2
}. This holds for the CEV process too since the CEV process is a special
case of the SABR process. In terms of our Monte Carlo simulation of the CEV/SABR
process, if S
t
starts not close to 0, we could construct an interval [a
1
, a
2
] such that with
large probability, the simulated path will be within the range, and we could consider the
discretized path as a good approximation of the true continuous path.
6.2 Strong Convergence of Mean-reverting CEV Process
Kahl and Jackel (2006) consider a stochastic volatility process which they call it mean-
reverting CEV process. It is dened as follows:
dV
t
= ( V
t
)dt + V
t
dW
t
. (6.13)
They point out that the boundary behavior of the process as follows.
1. 0 is an attainable boundary for 0 < <
1
2
and for =
1
2
if <

2
2
.
46
2. 0 is unattainable for >
1
2
.
3. is unattainable for all > 0.
They also develop a numerical scheme to simulate the stock process whose volatility process
is the mean-reverting CEV process.
There is a lot literature on the particular case of the mean-reverting CEV process, when
=
1
2
, which is called the mean-reverting square-root process. In the Heston model, the
volatility process is the mean-reverting square-root process. For the mean-reverting square-
root process, Higham and Mao (2005) propose a discretisation scheme called the reection
Euler scheme:
V
t
t+t
= V
t
t
+ ( V
t
t
)t +
_
|V
t
t
|W
t
, W
t
= W
t+t
W
t
. (6.14)
They prove that this discretisation scheme has the strong convergency property. They also
propose a discretisation scheme for the Heston model as follows:
S
t
t+t
=
_
|V
t
t
|S
t
t
W
1,t
,
V
t
t+t
= V
t
t
+ ( V
t
t
)t +
_
|V
t
t
|W
2,t
, corr(W
1,t
, W
2,t
) = .
(6.15)
They prove that such discretized process S
t
will converge to the true process S. This result
serves as the theoretical foundation for our Monte Carlo simulation of the DH process.
We extend the strong convergence to the general mean-reverting CEV process under the
following conditions:
Condition A: 0 < t < 2 and |(1 t)
2
+
2
t| < 1.
Condition B:
1
2
< 1.
We consider the discretisation scheme with reection principle on the time points t
n
=
nt, with n = 1, ..., N and Nt = T as follows:
V
t
t+t
= V
t
t
+ ( V
t
t
)t + |V
t
t
|
W
t
, W
t
= W
t+t
W
t
. (6.16)
Proposition 6.2.1 gives the rst moment of the discretized process (6.16). Proposition 6.2.2
says that the second moment of the discretized process (6.16) is bounded. Theorem 13 says
that the discretisation scheme (6.16) converges to the true process (6.13) as t 0 in L
1
sense.
47
Proposition 6.2.1. For the discretized process (6.16),
EV
t
n
= (1 t)
n
(EV
t
0
) + , (6.17)
so that when 0 < t < 2,
lim
t
EV
t
t
. (6.18)
Proof. For SDE in (6.16), take the expectation of both sides,
EV
t
n+1
= EV
t
n
(1 t) + t (6.19)
EV
t
n+1
= (1 t)(EV
t
n
) (6.20)
EV
t
n+1
= (1 t)
n
(EV
t
0
) + . (6.21)
So when 0 < t < 2, lim
t
EV
t
t
; otherwise, lim
t
EV
t
t
.
Proposition 6.2.2. For the discretized process (6.16), under conditions A and B, E(V
t
n
)
2
and E(V
t
n
)
2
is bounded for all n.
Theorem 13. For the mean-reverting CEV process in (6.13), under conditions A and B,
the discretisation process in (6.16) will have the L
1
convergence:
lim
t0
sup
0tT
E|V
t
V
t
t
| = 0. (6.22)
6.3 Discretisation Schemes Used in the Monte Carlo Simulation
In the Monte Carlo simulation conducted in Chapter 5, we use discretisation schemes to
simulate the processes whose exact simulation is dicult. Based on the discussion in section
6.1 and 6.2, the rst order LogEuler scheme is applied to simulate the DL process and
the CEV/SABR process. The rst order Euler scheme with reection principle is applied to
simulate the DH process. The discretisation schemes for each process are summarized below.
48
First order LogEuler scheme:
Denote z N(0, t), w N(0, t), wz.
Discretisation of the displaced lognormal process (exact simulation):
log(S
t
t
) =
2
2
t + z
Discretisation of the displaced anti -lognormal process (exact simulation):
log( S
t
t
) =
2
2
t + z.
Discretisation of the CEV/SABR process:
log S
t
t
=
t
(S
t
t
)
1
t
1
2
2
t
(S
t
t
)
22
z,
log
t
=
2
2
t + (z +
_
1
2
w).
First order LogEuler scheme with reection principle:
Denote z N(0, t), w N(0, t), wz.
Discretisation of the displaced Heston process:
log(S
t
t
) =
V
t
t
2
t +
_
|V
t
t
|z;
V
t
t
= ( V
t
t
)t +
_
|V
t
t
|w.
Discretisation of the displaced anti -Heston process:
log( S
t
t
) =
V
t
t
2
t
_
|V
t
t
|z;
V
t
t
= ( V
t
t
)t +
_
|V
t
t
|w.
49
CHAPTER 7
LARGE-EXPIRY IMPLIED VOLATILITY OF DISPLACED
LOGNORMAL
7.1 Large-strike and Large-expiry Behavior
In this section, we analyze the implied volatility of the displaced lognormal dynamics (2.6)
in the large-strike and large-expiry region. Our goal is to give a large-expiry asymptotes of
imp
(K, T).
7.1.1 Case one: K = S
0
e
xT
, x R/[
1
2
2
,
1
2
2
]
First, consider the strike to be K = S
0
e
xT
, where x is constant. Denote x(T) =
1
T
log((K
)/(S
0
)). Dene the domain of T as follows:
K
T
:= {T > 0 : S
0
e
xT
>
+
and (S
0
K)
+
< C
BS
(S
0
, S
0
e
xT
, , T) < S
0
}. (7.1)
The implied volatility
imp
(x, T) is dened on K
T
such that
C
BS
(S
0
, K,
imp
(x, T), T) = C
BS
(S
0
, K , , T). (7.2)
We can suppress the x in
imp
(x, T) to be
imp
(T) when no ambiguity arises.
Theorems 14, 15 and 17 give the large-expiry asymptotic approximation of
imp
(x, T),
where Theorem 14 focuses on the region where x R/[
1
2
2
,
1
2
2
], Theorems 15 and 17 on
the region where x (
2
/2,
2
/2).
Denote
A(T) =
( x(T) +
1
2
2
)
2
2
2
(7.3)
and dene the domain
K
x
:= {T R
+
: A(T) + x 0} (7.4)
50
Theorem 14. For the displaced lognormal mordel (2.6), if x R/[
1
2
2
,
1
2
2
] and T
K
T
K
x
, then the following asymptotic limit of
2
imp
(x, T) holds.
2
imp
(x, T) =
2
(x, T) + a
1
(x, T)/T + o(1/T) as T , (7.5)
where
(x, T) := 2
_
2A(T) + x 2
_
A
2
(T) + A(T)x
_
, if x R/[
1
2
2
,
1
2
2
] (7.6)
A
BS
(x, , a
1
) := exp
_
1
8
a
1
_
4x
2
4
1
__

3
x
2
4
/4
1
x=
2
/2
(7.7)
a
1
(x, T) = 2(
x
2
(x)

1
4
)
1
log
_
S
0
S
0
A
BS
( x, , 0)
A
BS
(x,
, 0)
_
. (7.8)
Proof. Appendix D.1.
We suppress the T in x(T), A(T),
2
(x, T), a
1
(x, T) to be x, A,
2
(x), a
1
(x), with
the understanding that these variables all depend on T.
Remark 7.1.1. Figure 7.1.1 shows the exact
imp
and Theorem 14 formula. We can see that
the approximation is reasonably accurate.
imp
for T = 10.
0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
0.05
0.1
0.15
0.2
0.25
0.3
x
im
p

S
0
=100, =0.2, =20, T=10
S
0
=100, =0.2, =60, T=10
imp
Theorem 14 formula
Remark 7.1.2. We can write A + x =
( x+
2
/2)
2
2
+ (x x) and lim
T
x(T) = x, so if
x R/[
1
2
2
,
1
2
2
], the condition A + x > 0 always holds for large T.
51
Remark 7.1.3. The derivation of Theorem 14 depends on whether x R/[
1
2
2
,
1
2
2
] or
not. However, since x will be in a close neighborhood of x when T is large, we express the
condition in terms of x.
Remark 7.1.4. If > 0 and x < 0, the strike K will eventually become less than as T
increases. Thus S
T
> > K, the option price will always be S
0
K for large T. (7.5)
should be regarded as an approximation of the implied volatility on the domain of T where
S
0
e
xT
>
+
.
7.1.2 Case two: K = S
0
e
xT
, x (
2
/2,
2
/2)
Theorem 15 gives the large-expiry asymptotic approximation of
imp
(x, T) in the region
which is complement to that in Theorem 14. Theorems 17 and 18 rene the approximation
to higher orders.
Theorem 15. For the displaced lognormal process (2.6), when x (
2
/2,
2
/2),
1. If < 0, then
imp
(x, T) is not dened for large T.
2. If > 0, for T K
T
and x [0,
2
/2), then
lim
T
imp
(x, T) = 2x. (7.9)
Before stating Theorem 17, we give an asymptotic approximation of the Black-Scholes
call option in the large-strike, large-expiry case.
Theorem 16. For x > 0, for B R, lim
T
a(T) = const, we have the asymptotic
behavior for the Black-Scholes call option formula in the large-strike, large-expiry case as
follows.
1
S
0
C
BS
(S
0
, S
0
e
xT
,
2x + 2B
_
2x
T
+
a(T)
T
, T) = N(B)+
e
1
2
B
2
(a(T)/2 B
2
1)
2T
2x
(1+O(1/
T)).
(7.10)
52
Remark 7.1.5. Forde et al (2009) give the asymptotic behavior of the Black-Scholes call
option when the volatility is expressed as
_
2
+ a/T. Theorem 16 is dierent from theirs
in that we have order of 1/
T and we restrict the leading term

2
to be 2x.
Theorem 17 renes the asymptotic behavior given in Theorem 15. It elaborates to higher
order of approximation.
imp
.
2 3 4 5 6 7 8 9 10
x 10
4
0.0762
0.0763
0.0764
0.0765
0.0766
0.0767
0.0768
0.0769
0.077
Time
i
m
p

S
0
=100, =0.2, =60, x=0.003
imp
approx
imp
Theorem 17. For the displaced lognormal process (2.6), if > 0, x (0,
2
/2) and T K
T
,
the second order approximation of
imp
(x, T) when T is given as:
2
imp
(x, T) = 2x + 2B
_
2x
T
+
a(T)
T
+ o(
1
T
), (7.11)
where B = N
1
(
S
0
S
0
), a(T) = 2(B
2
+1+C(T)e
1
2
B
2
2x), C(T) =

S
0
S
0
e
1
2
(
x
2
2
x+
2
4
)T
(

3
x
2
4
/4
).
Proof. See appendix D.4.
Remark 7.1.6. Figure 7.1.2 shows the approximation in Theorem 17 is highly accurate when
T is large. In the plot, we have T [2 10
4
, 10
5
].
53
Theorem 18 renes Theorem 17s approximation to the order of
1
T
T
.
Theorem 18. For the displaced lognormal process (2.6), if > 0, x (0,
2
/2) and T K
T
,
the third order approximation of
imp
(x, T) as T is given as:
2
imp
(x, T) = 2x + 2B
_
2x
T
+
a
T
+
d(T)
T
T
+ o(
1
T
T
) (7.12)
where B = N
1
(
S
0
S
0
), a = 2(B
2
+ 1), d(T) =
5B
3
+3B+C(T)e
B
2
/2
4x
2x
,
C(T) =

S
0
S
0
e
1
2
(
x
2
2
x+
2
4
)T
(

3
x
2
4
/4
).
Figures 7.1.3 and 7.1.4 compare Theorem 17 and Theorem 18s approximations of
imp
.
In both gures, the left plot is the Theorem 17 formula and the exact
imp
, and the right
plot is the Theorem 18 formula and the exact
imp
. In Figure 7.1.3, T [2000, 10000] and
in Figure 7.1.4, T [200, 1000]. All the other parameters are the same. We can see that for
T [2000, 10000], Theorem 18 signicantly improves the results of Theorem 17. However,
neither of them are a good approximation for T [200, 1000] . To sum up, Theorem 18 gives
a good approximation of
imp
when T is large.
Theorem 19 gives an explicit formula for the at-the-money implied volatility.
Theorem 19. For the displaced lognormal process (2.6), the at-the-money implied volatility
on T K
T
is
imp
(0, T) =
2
T
N
1
_
S
0
S
0
N(
T/2) +

2S
0
_
. (7.13)
Thus
lim
T
imp
(0, T)
T = 2N
1
_
1

2S
0
_
(7.14)
Remark 7.1.7. For
imp
(0, T) to exist, we need
S
0
S
0
N(
T/2) +

2S
0
[0, 1]. So, when
< 0,
imp
(0, T) becomes undened for large T.
54
7.1.3 Case three: K = S
0
e
xT
Theorem 14 can be extended to the region where K approaches such that K = S

0
e
xT
for x = 0 and > 1. This is given in Theorem 20.

Denote x =
1
T
log(
S
0
e
xT
S
0
), M = xT
1
,

M = xT
1
, A =
_

M+
2
/2
_
2
. Dene
the domain of T as
K
T
:= {T > 0 : S
0
e
xT
>
+
and (S
0
S
0
e
xT
)
+
< C
BS
(S
0
, S
0
e
xT
, , T) < S
0
},
(7.15)
the implied volatility
imp
(x, T) is well dened by (2.5) when T K
T
.
Theorem 20. For displaced lognormal dynamics (2.6), for x > 0, T K
T
, we have
2
imp
(x, T) =
2
+ a
1
(T)/T + o(1/T), (7.16)
where
= 2(M + A
_
2MA + A
2
), (7.17)
a
1
= 2(
M
2
1
4
)
1
log
_

S
0
S
0
A
BS
(

M, , 0)
A
BS
(M,
, 0)
_
, (7.18)
and A
BS
(.) is dened by (7.7).
Figure 7.1.5 and 7.1.6 compare the Theorem 20 formula and the exact
imp
. We can see
the approximation is accurate with moderate T. In Figure 7.1.5, the smallest K is about 700;
in Figure 7.1.6, the smallest K is about 200. Letting K approaches innity in the fashion of
K = S
0
e
xT
, we could have a highly accurate approximation of

imp
with reasonable expiry
time T.
Remark 7.1.8. In both Theorems 14 and 20, we have to make the strike K large to have
reasonably accurate approximation. Theorem 14 uses a large x (e.g. x = 0.2, T = 10, = 1)
to obtain a good approximation; Theorem 20 uses a small x but a large (e.g. x =
0.003, T = 10, = 3).
55
7.2 Fixed-strike Large-expiry Implied Volatility
In this section, we x the strike, and analyze the implied volatility of the displaced lognormal
dynamics when time to expiry is large. We show the asymptotic behavior and the mono-
tonicity of the implied volatility. In this section, denote K = S
0
e
x
, where x is a constant
and dene the domain of T as
K
T
:= {T > 0, (S
0
K)
+
< C
BS
(S
0
, K , , T) < S
0
}. (7.19)
imp
(x, T) is well-dened when T

K
T
by (2.5).
Theorem 21. For the displaced lognormal process (2.6), the xed-strike large-expiry implied
volatility has the following properties.
1. (Asymptotic behavior).
(a) For all K >
+
, T K
T
and 2S
0
> > 0,
lim
T
imp
(x, T)
T =
blsimpv
(S
0
, K, S
0
), (7.20)
where
blsimpv
(S
0
, K, P) is the implied volatility of the one-year call option with
price P dened as follows:
C
BS
(S
0
, K,
blsimpv
(S
0
, K, P), 1) = P. (7.21)
(b) For < 0, the
imp
(x, T) is not dened when T .
2. (Monotonicity in time) For all > 0, K >
+
and T K
T
lim
T
sgn
imp
T
(x, T) = sgn (7.22)
Theorem 22 renes the results of Theorem 21.1. The notation A(T) B(T) means
A(T)/B(T) 1 as T .
56
Theorem 22. For the displaced lognormal dynamics with K = S
0
e
x
, the following holds for
the xed-strike, large-time implied volatility:
imp
(x, T)
1
T
_
blsimpv
(S
0
, K, S
0
) + z
_
, (7.23)
where z =
1+
_
1+4M(
1
8
+
x
2
8a
2
)
1
4
+
x
2
4a
2
, a =
2
blsimpv
(S
0
,K,S
0
)
2
,
M =
2 exp(
1
2
(
x+a
2a
)
2
)
_
1
S
0
C
BS
(S
0
, K , , T)
S
0
S
0
_
.
Figure 7.2.1 shows Theorem 22 formula and exact
imp
. We can see that for close to
S
0
the approximation is quite accurate even for moderate large T.
57
Figure 7.1.3: Theorems 17 and 18 formula and Exact
imp
.
2000 3000 4000 5000 6000 7000 8000 9000 10000
0.076
0.0765
0.077
0.0775
0.078
0.0785
0.079
0.0795
Time
im
p

S
0
=100, =0.2, =60, x=0.003
Exact
imp
approximated
imp
2000 3000 4000 5000 6000 7000 8000 9000 10000
0.0762
0.0764
0.0766
0.0768
0.077
0.0772
0.0774
0.0776
0.0778
0.078
Time
im
p

S
0
=100, =0.2, =60, x=0.003
Exact
imp
approximated
imp
Figure 7.1.4: Theorems 17 and 18 formula and Exact
imp
.
200 300 400 500 600 700 800 900 1000
0.08
0.085
0.09
0.095
0.1
0.105
Time
im
p

S
0
=100, =0.2, =60, x=0.003
Exact
imp
approximated
imp
200 300 400 500 600 700 800 900 1000
0.076
0.077
0.078
0.079
0.08
0.081
0.082
0.083
0.084
0.085
0.086
Time
im
p

S
0
=100, =0.2, =60, x=0.003
Exact
imp
approximated
imp
58
imp
for T = 10.
3 4 5 6 7 8 9 10
x 10
3
0.15
0.155
0.16
0.165
0.17
0.175
0.18
0.185
x
i
m
p

S
0
=100, =0.2, =60 ,T=10, =3
Exact
imp
approximated
imp
imp
for T = 7.
3 4 5 6 7 8 9 10
x 10
3
0.105
0.11
0.115
0.12
0.125
0.13
0.135
0.14
0.145
0.15
x
i
m
p

S
0
=100, =0.2, =60, =2.8 ,T=7
Exact
imp
approximated
imp
59
imp
for T = 20.
0.4 0.3 0.2 0.1 0 0.1 0.2 0.3
0.1
0.11
0.12
0.13
0.14
0.15
0.16
0.17
0.18
x
i
m
p

S
0
=100, =0.4, =60, T=20
imp
approx
imp
60
CHAPTER 8
CONCLUSION
By establishing properties shared by all displaced lognormal volatility skews, Theorems 1 and
2, in eect, exhibit limitations on what phenomena the displaced lognormal can faithfully
model. In particular, the displaced lognormals everywhere-monotonic skews (Theorem 1)
and its state space (, ) = R
+
may be drawbacks, when pricing contracts having sensitivity
to the tail behavior of an underlying process whose true state space is R
+
or whose true
volatility skew is non-monotonic. The slope-constrained skew (Theorem 2) of the displaced
lognormal may be a drawback, when modeling markets, such as typical equity markets,
which exhibit downward skews of steepness greater than the Theorem 2 upper bound. The
displaced anti -lognormal overcomes the slope constraint, but it imposes bounds from above
on S, while allowing unbounded negative S. Furthermore, the displaced anti -lognormal has
the everywhere-monotonic skews (Theorem 4).
We therefore do not endorse the DL as a model of equity markets, but we do propose the
DL as a control variate to improve the accuracy of Monte Carlo pricing under alternative
dynamics (such as CEV and SABR) that do model equity prices. The DL is eective as a
control variate, because it is simple enough to admit both unbiased simulation and explicit
pricing formulas for many contracts, yet exible enough to generate high correlations and
hence signicant variance reduction with respect to the CEV/SABR dynamics. We give
two examples. The rst is the down-and-out call option under the CEV/SABR dynamics.
The DL control generates large variance reduction as shown in Table 5.1.1 and 5.1.2. The
second example is the discrete arithmetic Asian option. We compare the variance reduction
of the DL control and the lognormal control. The DL control generates signicant more
satisfactory variance reduction than LN control as shown in Table 5.1.4 and 5.1.5.
Another displaced process, the displaced (anti -)Heston process, will generate more vari-
ance reduction when used as control variate. We are able to have explicit pricing formulas
for the calls/puts and barrier options on the DH process. Though no exact simulations of
the DH process are available, we have a discretisation scheme which guarantees convergence
61
to the true process. We show that DH control improves the variance reduction of DL control
when applied to the SABR dynamics in Table 5.1.3.
Moreover, we analyze the variance reduction by combining the DL/DH control variate
with importance sampling. The combined technique is superior to the pure importance
sampling when applied to options under the SABR dynamics, as shown in Table 5.2.1 and
5.2.2, Table 5.2.3 and 5.2.4.
Toward either purpose as a model, or as a computational device on behalf of another
model the DL calibrates easily to a given volatility skew level and slope, via the short-
expiry limiting implied volatility formula of Theorems 3 and 6; and the DH calibrates easily
to a given volatility skew level, slope and convexity, via the short-expiry limiting implied
volatility formula of Theorems 8 and 9.
Furthermore, we give an explicit relationship between the short-expiry implied volatilities
of any process which is a positive martingale with its corresponding (anti-)displaced process
(Theorems 10 and 11). Combined with Durrlemans (2004) approximation of the short-expiry
near-the-money implied volatility, we are able to give an approximation of the short-expiry
near-the-money implied volatility of any (anti-)displaced process.
In contrast to the short-expiry limiting implied volatility, the large-expiry limiting implied
volatility of the displaced lognormal is also analyzed. We rst give the approximation of the
implied volatility in the large-strike case (Theorems 14, 15, 17 and 18 where K = S
0
e
xT
;
Theorem 20 where K = S
0
e
xT
). Secondly, we give the approximation of the implied

volatility in the xed-strike case (Theorems 21 and 22).
Finally, we discuss some issues in the discretisation scheme of the Monte Carlo simulation.
Under some regularity conditions, we prove the partial strong convergency of the discretized
stochastic volatility process to the continuous process (Theorem 12). We also prove a strong
convergency result of the mean-reverting CEV process (Theorem 13).
62
APPENDIX A
A.1 Appendix: Proof of Theorem 1Global Behavior of
Displaced Lognormal
Dene for all K >
+
d
2
(K) :=
log[(S
0
)/(K )]
T
2
.
Let K
S
(T) := inf K
S
(T). Our notation may suppress the S or T. Note that K = (K, ).
If 0 then K = . If < 0 then K > 0 because C
BS
(S
0
, 0, ) > S
0
+ = S
0
.
Proposition A.1.1. For all T > 0 and K K(T):
If > 0 then
imp
(K) < . If < 0 then
imp
(K) > .
Proof. For all K > and S
0
> ,
d
d
C
BS
(S
0
, K , ) =
C
BS
S

C
BS
K
= N(d
2
+
T) + N(d
2
) < 0 (A.1)
so, according as 0, we have C
BS
(S
0
, K , ) C
BS
(S
0
, K, ). By (2.9),
imp
(K) . (A.2)
for all K K.
Proposition A.1.2. For all T > 0, we have
imp
(K) as K .
Hence sup
KK(T)
imp
(K) = if > 0; and inf
KK(T)
imp
(K) = if < 0.
Proof. We prove for > 0. The proof for < 0 is similar.
By Proposition A.1.1,
imp
(K) < for all K K. So it suces to show that for all
> 0, there exists k such that for all K > k,
<
imp
(K)
63
or equivalently
C
BS
(S
0
, K, ) < C
BS
(S
0
, K,
imp
(K)) = C
BS
(S
0
, K , ).
Hence it suces that for K large enough,
0 < M(K) := C
BS
(S
0
, K , ) C
BS
(S
0
, K, ), (A.3)
which we verify as follows. For all K >
+
,
M
K
= N
_
log[(S
0
)/(K )]
T
2
_
+ N
_
log(S
0
/K)
( )
( )
T
2
_
. (A.4)
So
sgn
M
K
= sgn
_
log(S
0
/K)
( )
log[(S
0
)/(K )]
T
+

T
2
_
(A.5)
= sgn
_
log(S
0
/K)
log[(S
0
)/(K )]
( )
T
+

T
2
_
(A.6)
= sgn
_
log[(S
0
(K ))/(K (S
0
))]
log[(K )/(S
0
)]
( )
T
+

T
2
_
.
(A.7)
The part inside the sgn in (A.7) approaches as K .
So for K suciently large, M/K(K) < 0.
Moreover lim
K
M(K) = 0 0 = 0.
Therefore M(K) > 0 for K suciently large, which proves (A.3).
Lemma A.1.3. For all K K,
sgn
imp
K
(K) = sgn F(
imp
(K), K)
where F : R (
+
, ) R is dened by
F(y, K) := y
2
T/2 y
Td
2
(K) + log(S
0
/K).
64
Proof. Take the K derivative of (2.9),
C
BS
K
(S
0
, K,
imp
(K)) +
C
BS
(S
0
, K,
imp
(K))
imp
K
(K) =
C
BS
K
(S
0
, K , ).
(A.8)
Therefore
sgn
imp
K
(K) = sgn
_
C
BS
K
(S
0
, K , )
C
BS
K
(S
0
, K,
imp
(K))
_
= sgn
__
log(S
0
/K)
imp
imp
T
2
_
d
2
(K)
_
= sgn
_
2
imp
(K)T/2
imp
(K)
Td
2
(K) + log(S
0
/K)
= sgn F(
imp
(K), K),
as claimed.
Lemma A.1.4. There exists K K such that
sgn
imp
K
(K) = sgn .
Proof. If = 0 then this is obvious.
If < 0 then as K K we have C
BS
(S
0
, K , ) S
0
hence
imp
. So there
exists K > K such that
imp
/K(K) < 0, as claimed.
If > 0 then the at-the-money strike K = S
0
satises the conclusion, because
sgn
imp
K
(S
0
) = sgn
_
imp
(S
0
)
T/2 +
T/2
> 0
by Proposition A.1.1.
Proposition A.1.5. For all T > 0 and K K(T),
sgn
imp
K
(K) = sgn . (A.9)
Proof. If = 0 then this is obvious. Otherwise, by Lemma A.1.4 the conclusion holds
for at least one K K. By continuity of

imp
K
on K, the conclusion will hold for all
K K, if we can show that
imp
/K = 0 on K, or equivalently (by Lemma A.1.3) that
65
F(
imp
(K), K) = 0 for all K K. The remaining lemmas complete the proof, by verifying
that F(
imp
(K), K) = 0.
For K >
+
dene
(K) := d
2
2
(K) + 2 log(S
0
/K) (A.10)
h(K) := d
2
(K) +
T
K
K
. (A.11)
Let
D := {K >
+
: (K) 0},
and for all K D, dene
y
(K) :=
d
2
(K)
_
(K)
T
. (A.12)
Lemma A.1.6. For (y, K) R K, we have F(y, K) = 0 if and only if K D and
y = y
(K).
Proof. If K / D then F(, K) is a quadratic with no real roots. If K D then F(, K) has
roots y = y
(K).
Lemma A.1.7. For all K D dene
H
(K) := S
0
N(
_
(K)) (S
0
)N(d
2
(K) +
T) N(d
2
(K))
Then for all K D K,
H
(K) = C
BS
(y
(K)) C
BS
(
imp
(K))
where C
BS
() is shorthand for C
BS
(S
0
, K, ).
Hence y
+
(K)
imp
(K) if H
+
(K) 0. Likewise y
(K)
imp
(K) if H
(K) 0.
66
Proof. Using log(S
0
/K)/(y
(K)
T) y
(K)
T/2 = d
2
(K) and (2.9), we have
C
BS
(y
(K)) C
BS
(
imp
) =
_
S
0
N
_
log(S
0
/K)
y
(K)
T
+
y
(K)
T
2
_
KN(d
2
(K))
_
_
(S
0
)N(d
2
(K) +
T) (K )N(d
2
(K))
_
= S
0
N(d
2
(K) + y
(K)
T) (S
0
)N(d
2
(K) +
T) N(d
2
(K))
= H
(K)
The remaining conclusion is by monotonicity of C
BS
.
Lemma A.1.8. If 0 then for all K D we have
_
(K) |h(K)|.
Proof. Consider only the case > 0. The proof for < 0 is similar.
We need to show that for all K D,
d
2
2
(K) + 2 log(S
0
/K) > d
2
2
(K) +
_
K
K
_
2
2
T + 2d
2
(K)
T
K
K
or equivalently that
__
K
K
_
2
_
K
K
__
2
T +2
K
K
log[(S
0
)/(K )] 2 log(S
0
/K) < 0. (A.13)
The rst term is negative, because 0 < (K )/K < 1; so it suces to show that for all
K > ,
L(K) :=
K
K
log[(S
0
)/(K )] log(S
0
/K) 0.
This is veried by L(S
0
) = 0 and L/K = (/K
2
) log[(S
0
)/(K)] 0 for K S
0
.
Lemma A.1.9. For all K >
+
:
If > 0 then K D and
H
K
> 0,
H
+
K
> 0.
If < 0, h(K) > 0 then

K
(K) < 0. If moreover K D then
H
K
(K) > 0,
H
+
K
(K) <
0.
If < 0, h(K) < 0 then

K
(K) > 0. If moreover K D then
H
K
(K) < 0,
H
+
K
(K) >
0.
67
Proof. The conclusions hold because
K
(K) =
2h(K)
(K )
T
.
If > 0, the K D conclusion clearly holds for K (S
0
, ), and also holds for K (, S
0
]
because
log[(S
0
)/(K )]/(
T)
T/2 < log(S

0
/K)/(
T)
T/2 < 0
implies
(K) > (log(S
0
/K)/(
T)
T/2)
2
+2 log(S
0
/K) = (log(S
0
/K)/(
T)+
T/2)
2
0.
Lastly, in all cases, the H
conclusions hold because of

H
K
(K) =
1
2
Ke
d
2
2
(K)/2
(K )
T
_
(K)
_
_
(K) h(K)
_
and Lemma A.1.8.
Lemma A.1.10. If > 0 then for all K K = (, ), we have K D and
y
1
(K) <
imp
(K) < y
2
(K).
Proof. By Lemma A.1.9 we have K D and y
(K) are well-dened.

To prove
imp
< y
+
, note that as K we have d
2
(K) hence H
+
(K) 0.
Moreover, H
+
/K > 0 on K, by Lemma A.1.9. So on K we have H
+
> 0, hence
imp
< y
+
by Lemma A.1.7.
To prove y
<
imp
, note that as K we have d
2
(K) hence H
(K) 0.
Moreover, H
/K > 0 on K, by Lemma A.1.9. So on K we have H
< 0, hence y
<
imp
by Lemma A.1.7.
Lemma A.1.11. If < 0 then for each K K D we have
imp
(K) / [y
(K), y
+
(K)].
68
Proof. Because < 0, it is clear that h is decreasing on (0, ).
Because K D, we have h(K) = 0 by Lemma A.1.8.
If h(K) < 0, then for all k > K we have h(k) < 0 and /K(k) > 0 by Lemma
A.1.9. So for all k > K we have k D and
H
K
(k) < 0 by Lemma A.1.9. Moreover
lim
k
H
(k) = 0. Therefore H
(K) > 0, hence

imp
(K) < y
(K) by Lemma A.1.7.

If h(K) > 0, then for all k (0, K) we have h(k) > 0 and /K(k) < 0 by Lemma
A.1.9. So for all k (0, K) we have k D and
H
+
K
(k) < 0 by Lemma A.1.9. Moreover, as
k 0, we have (k) , hence
H
+
(k) S
0
(S
0
)N
_
log[(S
0
)/()]
T
+

T
2
_
N
_
log[(S
0
)/()]
T
2
_
= S
0
C
BS
(S
0
, , ) < S
0
(S
0
+ ) = 0.
Therefore H
+
(K) < 0, hence y
+
(K) <
imp
(K) by Lemma A.1.7.
Lemma A.1.12. For all K K we have F(
imp
(K), K) = 0.
Proof. Combine Lemmas A.1.10, A.1.11, and A.1.6.
A.2 Appendix: Proof of Theorem 2At-the-money Behavior of
Displaced Lognormal
Proof of Theorem 2.1. Taking K = S
0
in (2.9), we have
C
BS
(S
0
, S
0
,
atm
) = C
BS
(S
0
, S
0
, ), (A.14)
hence
S
0
[2N(
atm
T/2) 1] = (S
0
)[2N(
T/2) 1], (A.15)

and
N(
atm
T/2) =
S
0
2S
0
[2N(
T/2) 1] +
1
2
= (1

S
0
)N(
T/2) +

S
0
N(0) N((1

S
0
)d
1
)
(A.16)
for 0, because N(x) is concave on x 0. Monotonicity of N implies
atm
(1/S
0
).
Similarly, for 0, we have
atm
(1 /S
0
).
69
Proof of Theorem 2.2. Using (A.8), we have
log
imp
log K
K=S
0
=
S
0
imp
imp
K
K=S
0
=
N(
atm
T/2) N(
T/2)
(
atm
T/2)
atm
T
, (A.17)
because < 0 implies
atm
> . By concavity of N on [0, ),
(
atm
T/2)
N(
atm
T/2) N(
T/2)
atm
T/2
T/2
(
T/2). (A.18)
Combining (A.17), (A.18), and Theorem 2.1 produces the lower bound
log
imp
log K
K=S
0

atm
2
atm
1
2
_
1
1
1 /S
0
_
=
||
2(S
0
+||)
. (A.19)
Combining (A.17) and (A.18) produces the upper bound
log
imp
log K
K=S
0

atm
2
atm
T/2)
(
atm
T/2)
1
2
e
2
atm
T/8
. (A.20)
as claimed.
A.3 Appendix: Proof of Theorems 3 and 6Short-expiry
Behavior of DL
The notation A(T) B(T) means that A(T)/B(T) 1 as T 0.
Proof of Theorem 3. For all K >
+
, we have C
BS
(S
0
, K , , T) (S
0
K)
+
as
T 0, so for all T suciently small, C
BS
(S
0
, K , , T) < S
0
hence K K
S
(T).
Applying Roper-Rutkowski (2007) Proposition 5.1 to the displaced lognormal model, we
have, as T 0,
imp
(K, T)
| log(S
0
/K)|
_
2T log(C
BS
(S
0
, K , , T) (S
0
K)
+
)
. (A.21)
On the other hand, applying it to the Black-Scholes model, we have, as T 0,

| log((S
0
)/(K ))|
_
2T log(C
BS
(S
0
, K , , T) (S
0
K)
+
)
. (A.22)
70
Therefore
imp
(K, T)
||| log(S
0
/K)|
| log((S
0
)/(K ))|
=
log(S
0
/K)
log((S
0
)/(K ))
(A.23)
as T 0.
Proof of Theorem 6. For all K (0, ), we have C
BS
( K, S
0
, , T) (S
0
K)
+
as
T 0, so for all T suciently small, C
BS
( K, S
0
, , T) < S
0
hence K K
S
(T).
Applying Roper-Rutkowski (2007) Proposition 5.1 to the displaced anti-lognormal model,
we have, as T 0,
imp
(K, T)
| log(S
0
/K)|
_
2T log(C
BS
( K, S
0
, , T) (S
0
K)
+
)
. (A.24)
On the other hand, applying it to the Black-Scholes model, we have, as T 0,

| log(( K)/( S
0
))|
_
2T log(C
BS
( K, S
0
, , T) (S
0
K)
+
)
. (A.25)
Therefore (A.23) holds.
A.4 Appendix: Proof of Theorem 4Global Behavior of
Displaced anti -Lognormal
Dene for all K <
d
2
(K) :=
log[( S
0
)/( K)]
||
||
T
2
.
Lemma A.4.1. For all K K
ADL
,
sgn
imp
K
(K) = sgn F(
imp
(K), K)
where F : R (0, ) R is dened by
F(y, K) := y
2
T/2 + y
Td
2
(K) + log(S
0
/K).
71
Proof. Taking the K derivative of (2.19),
C
BS
K
(S
0
, K,
imp
(K))+
C
BS
(S
0
, K,
imp
(K))
imp
K
(K) = 1
C
BS
K
(S
0
, K, ||).
(A.26)
Therefore
sgn
imp
K
(K) = sgn
_
1
C
BS
K
( S
0
, K, ||)
C
BS
K
(S
0
, K,
imp
(K))
_
= sgn
_
1 + N(d
2
(K)) + N
_
log(S
0
/K)
imp
(K)
imp
(K)
T
2
__
= sgn
__
log(S
0
/K)
imp
(K)
imp
(K)
T
2
_
+ d
2
(K)
_
= sgn
_
2
imp
(K)T/2 +
imp
(K)
Td
2
(K) + log(S
0
/K)
= sgn F(
imp
(K), K),
as claimed.
Lemma A.4.2. > S
0
> 0, there exists K K
ADL
such that
sgn
imp
K
(K) = sgn .
Proof. The at-the-money strike K = S
0
satises the conclusion, because
sgn
imp
K
(S
0
) = sgn
_
imp
(S
0
)
T/2 ||
T/2
< 0.
Proposition A.4.3. For all T > 0, K K
ADL
(T) and > S
0
,
sgn
imp
K
(K) = sgn . (A.27)
Proof. By Lemma A.4.2 the conclusion holds for at least one K K
ADL
. By continuity of
imp
K
on K
ADL
, the conclusion will hold for all K K
ADL
, if we can show that
imp
/K =
0 on K
ADL
, or equivalently (by Lemma A.4.1) that F(
imp
(K), K) = 0 for all K K. The
remaining lemmas complete the proof, by verifying that F(
imp
(K), K) = 0.
72
For K < dene
(K) := d
2
2
(K) + 2 log(S
0
/K) (A.28)
h(K) := d
2
(K) ||
T
K
K
. (A.29)
Let
D := {0 < K < : (K) 0},
and for all K D, dene
y
(K) :=
d
2
(K)
_
(K)
T
. (A.30)
Lemma A.4.4. For (y, K) R K
ADL
, we have F(y, K) = 0 if and only if K D and
y = y
(K).
Proof. If K / D then F(, K) is a quadratic with no real roots. If K D then F(, K) has
roots y = y
(K).
Lemma A.4.5. For all K D dene
H
(K) := S
0
N(
_
(K)) ( S
0
)N(d
2
(K) +||
T) + N(d
2
(K)) (A.31)
Then for all K D K
ADL
,
H
(K) = P
BS
(y
(K)) P
BS
(
imp
(K))
where P
BS
() is shorthand for P
BS
(S
0
, K, ).
Hence y
+
(K)
imp
(K) if H
+
(K) 0. Likewise y
(K)
imp
(K) if H
(K) 0.
Proof. Using log(S
0
/K)/(y
(K)
T) y
(K)
T/2 = d
2
(K) and (2.18), we have
P
BS
(y
(K)) P
BS
(
imp
) =
_
KN
_
log(S
0
/K)
y
(K)
T
+
y
(K)
T
2
_
S
0
N
_
log(S
0
/K)
y
(K)
(K)
T
2
__
_
( S
0
)N(d
2
(K) +||
T) ( K)N(d
2
(K))
_
= KN(d
2
(K)) S
0
N(d
2
(K) y
(K)
T) ( S
0
)N(d
2
(K) +||
T)
+ ( K)N(d
2
(K))
= H
(K)
73
The remaining conclusion is by monotonicity of P
BS
.
Lemma A.4.6. > S
0
, for all K D we have
_
(K) < |h(K)|.
Proof. We want to show:
h
2
(K)(K) =
__
K
K
_
2
+
_
K
K
__
2
T2
K
K
log[(S
0
)/(K)]2 log(S
0
/K) > 0.
(A.32)
The rst term is positive, because ( K)/K > 0; so it suces to show that for all K > ,
L(K) :=
K
K
log[( S
0
)/( K)] log(S
0
/K) 0.
This is veried by L(S
0
) = 0 and L/K = (/K
2
) log[(S
0
)/(K)] 0 for K S
0
.
Lemma A.4.7. For all 0 < K < :
If h(K) > 0 then

K
(K) > 0. If moreover K D then
H
K
(K) < 0,
H
+
K
(K) > 0.
If h(K) < 0 then

K
(K) < 0. If moreover K D then
H
K
(K) > 0,
H
+
K
(K) < 0.
Proof. The conclusion hold because:
(K)
K
=
2h(K)
( K)||
T
. (A.33)
The H
conclusions hold because of

H
K
(K) =
1
2
Ke
d
2
2
(K)/2
( K)||
T
_
(K)
_
_
(K) h(K)
_
.
Lemma A.4.8. If > 0 then for each K K
ADL
D we have
imp
(K) / [y
(K), y
+
(K)].
Proof. Because > 0 and
h(K)
K
=
1
K
1
||
T
+
||
T
K
2
> 0, h(K) is monotonically in-
creasing on (0, ). Furthermore h(0) = , h() = , so there is a point k
0
(0, ) such
that h(k
0
) = 0. By (A.33), (K) is decreasing on {K : 0 < K < k
0
} and increasing on
{K : k
0
< K < }.
74
Because K D, we have h(K) = 0 by Lemma A.4.6.
For a particular K D, if h(K) < 0, then for all k < K, we have h(k) < 0 and
/K(k) < 0 by Lemma A.4.7. So for all k < K and k D, we have
H
+
K
(k) < 0 by
Lemma A.4.7. Moreover, k 0, (k) , hence by (A.31)
lim
k0
H
+
(k) = 0 ( S
0
)N(d
2
(0) +||
T) + N(d
2
(0)) = 0 C
BS
( S
0
, , ||, T) < 0.
Therefore H
+
(K) < 0 hence y
+
(K) <
imp
(K) when K K
ADL
by Lemma A.4.5.
If h(K) > 0, then for all k (K, ), we have h(k) > 0 and /K(k) > 0 by Lemma
A.4.7. So for all k > K and k D, we have
H
K
(k) < 0 by Lemma A.4.7.
k = d
2
(k) = (k) = ,
H
() = S
0
N(
_
(k))(S
0
)N(d
2
(k)+||
T)+N(d
2
(k)) = S
0
(S
0
)+ = 0.
Therefore H
(K) > 0 hence y
(K) >
imp
(K) when K K
ADL
by Lemma A.4.5.
Lemma A.4.9. For all K K
ADL
we have F(
imp
(K), K) = 0.
Proof. Combine Lemmas A.4.4, and A.4.8.
A.5 Appendix: Proof of Theorem 5At-the-money Behavior of
Displaced anti -Lognormal
Proof of Theorem 5.1. Consider at-the-money in (2.19), we have,
S
0
[2N(
atm
T/2) 1] = ( S
0
)[2N(||
T/2) 1], (A.34)

and
N(
atm
T/2) =
S
0
2S
0
[2N(||
T/2) 1] +
1
2
= (

S
0
1)N(||
T/2) + (2

S
0
)N(0).
(A.35)
75
If

S
0
1 [0, 1], then
(

S
0
1)N(||
T/2) + (2

S
0
)N(0) N
_
(

S
0
1)
||
T
2
_
. (A.36)
Because N(x) is concave on x 0. Monotonicity of N implies
atm
(/S
0
1)||.
Similarly, if

S
0
1 [1, ), then
(

S
0
1)N(||
T/2) + (2

S
0
)N(0) N
_
(

S
0
1)
||
T
2
_
. (A.37)
Using the monotonicity of N, we have
atm
(/S
0
1)||.
Proof of Theorem 5.2. Re-order the entries in (A.26) and plug in (A.34), we have,
log
imp
log K
K=S
0
= =
1 + N(||
T/2) + N(
atm
T/2)
(
atm
T/2)
atm
K=S
0
(A.38)
=
N(||
T/2) + N(
atm
T/2) 1
(
atm
T/2)
atm
K=S
0
(A.39)
=
S
0
_
N(
atm
T/2) 1/2
_
(
atm
T/2)
atm
K=S
0
. (A.40)
By the concavity of N on [0, ):
(
atm
T/2)
N(
atm
T/2) N(0)
atm
T/2
(0). (A.41)
Combine (A.40) and (A.41), we have
2( S
0
)

log
imp
log K
K=S
0

2( S
0
)
exp(
2
atm
T/8) (A.42)
76
APPENDIX B
B.1 Appendix: Proof of Theorem 7At-the-money Behavior of
Displaced Independent Stochastic Volatility
Proof of Theorem 7. Dene the average volatility of the DISV process:
=
_
T
0

2
t
dt
T
. (B.1)
Since conditioning on the average volatility , the process S
T
is lognormal process,
E(S
T
K)
+
= E{E[(S
T
) (K )]
+
|} = E(C
BS
(S
0
, K , )).
For K K
DISV
, the implied volatility
imp
satises
C
BS
(S
0
, K,
imp
) = E(C
BS
(S
0
, K , )). (B.2)
Dierentiating with respect to K in (B.2) and exchanging the expectation and the dieren-
tiation (validate later), we have
C
BS
(S
0
, K,
imp
)
imp
imp
K
= E
_
C
BS
(S
0
, K , )
K

C
BS
(S
0
, K,
imp
)
K
_
. (B.3)
Since
C
BS
(S
0
,K,
imp
)
imp
> 0, we have
sgn
imp
K
K=S
0
= sgn E
_
C
BS
(S
0
, K , )
K

C
BS
(S
0
, K,
atm
)
K
_
K=S
0
(B.4)
= sgn E
_
N(
atm
T
2
) N(
T
2
)
_
(B.5)
= sgn
_
EN(
T
2
) N(
atm
T
2
)
_
. (B.6)
77
What remains is to show 0 N(
atm
T
2
) EN(
T
2
). Assuming the exchange-
ability of the expectation and the dierentiation, we have
E(C
BS
(S
0
, K , ))
= E
C
BS
(S
0
, K , )
= E(N(d
1
) + N(d
2
)) 0,
where d
1,2
=
log((S
0
)/(K))
2
T/2
T
. So E(C
BS
(S
0
, K , )) is monotonically de-
creasing as a function of . Thus,
0 E(C
BS
(S
0
, K , )) E(C
BS
(S
0
, K, )),
C
BS
(S
0
, K,
imp
) E(C
BS
(S
0
, K, )).
Particularly when at-the-money, we have
N(
atm
T
2
) EN(
T
2
). (B.7)
To complete the proof, we need to validate the exchangeability of the expectation and
the dierentiation. Since
C
BS
(S
0
, K , )
= | N(d
1
) + N(d
2
)| 2,
C
BS
(S
0
, K , )
K
= | N(d
2
)| 1,
we can use dominant convergent theorem to exchange the expectation and the dierentiation.
B.2 Appendix: Proof of Theorems 8 and 9 Short-expiry
Behavior of DH
Proof of Theorem 8. Denote C
DH
(S
0
, K, T) the call option price under the DH process,
with strike K, maturity T and initial value S
0
; and similarly C
H
(S
0
, K, T) the call option
price under the Heston process. We have C
DH
(S
0
, K, T) = C
H
(S
0
, K, T). Applying
78
Roper-Rutkowski (2007) corollary 5.1 to the displaced Heston model, we have, as T 0,
DH
imp
(K, T)
_
_
| log(S
0
/K)|
_
2T log(C
DH
(S
0
,K,T)(S
0
K)
+
)
if K = S
0
_
2C
DH
(S
0
, K, T)/(S
0
T) if K = S
0
(B.8)
On the other hand, applying it to the Heston model, we have, as T 0,
H
imp
(K , T)
_
_
| log((S
0
)/(K))|
_
2T log(C
H
(S
0
,K,T)(S
0
K)
+
)
if K = S
0
_
2C
H
(S
0
, K , T)/((S
0
)
T) if K = S
0
(B.9)
By comparing (B.8) and (B.9), and using (3.12), we have
lim
T0
DH
imp
(K, T) =
_
_
lim
T0
H
imp
(K , T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
H
imp
(K , T) (1 /S
0
) if K = S
0
.
(B.10)
Proof of Theorem 9. Denote C
ADH
(S
0
, K, T) the call option price under the displaced anti -
process, with strike K, maturity T and initial value S
0
; and similarly C
H
(S
0
, K, T) the call
option price under the Heston process. Let

S = S,

K = K. Using put-call parity,
we have
E(S
T
K)
+
(S
0
K)
+
= E(

K

S
T
)
+
(

K

S
0
)
+
= E(
S
T

K)
+
(
S
0

K)
+
. (B.11)
If at-the-money, then,
E(S
T
K)
+
= E(
S
T

K)
+
. (B.12)
Applying Roper-Rutkowski (2007) corollary 5.1 to the displaced anti-Heston model, we
have, as T 0,
ADH
imp
(K, T)
_
_
| log(S
0
/K)|
_
2T log(C
ADH
(S
0
,K,T)(S
0
K)
+
)
if K = S
0
_
2C
ADH
(S
0
, K, T)/(S
0
T) if K = S
0
(B.13)
79
Applying it to the Heston model, we have, as T 0,
H
imp
( K, T)
_
_
| log((S
0
)/(K))|
_
2T log(C
H
(S
0
,K,T)((S
0
)(K))
+
)
if K = S
0
_
2C
H
( S
0
, K, T)/(( S
0
)
T) if K = S
0
(B.14)
By comparing (B.13) and (B.14), and using (B.11) and (B.12), we have
lim
T0
ADH
imp
(K, T) =
_
_
lim
T0
H
imp
( K, T)
log(S
0
/K)
log((S
0
)/(K ))
if K = S
0
lim
T0
H
imp
( K, T) (1 /S
0
) if K = S
0
.
(B.15)
B.3 Appendix: Proof of Propositions 3.1.2 and 3.2.1Level,
Slope and Convexity of DH Short-expiry Implied Volatility
Proof of Proposition 3.1.2. We utilize the short-expiry approximation formula of the implied
volatility given by Durrleman (2004) and the relationship between the implied volatilities of
the DH model and the Heston model (Theorems 8 and 9).
Denote

S
t
= S
t
,

K = K . Durrleman (2004) shows that, the near-money short-
expiry implied volatility with strike

K, maturity T and initial value

S
0
is
H
imp
(

K, T) =
_
2
0
+ a
0
log(
S
0
/

K) + b
0
T
2
+
c
0
2
log
2
(
S
0
/

K) + O(log(
S
0
/

K)T + T
2
).
(B.16)
It can be approximated as
H
imp
(

K, T)
_
2
0
+ a
0
log(
S
0
/

K) + b
0
T
2
+
c
0
2
log
2
(
S
0
/

K), (B.17)
where A(T) B(T) means A(T)/B(T) 1 as T 0 and
a
0
=
2
, c
0
=

2
6
2
0
(1
7
2
4
), b
0
= (
2
0
) +

2

2
0

2
6
(1
2
/4). (B.18)
Since we have specied that = 0 for the Heston process, we have a
0
= 0. In the following,
we give a limit approximation of the level, slope and convexity as T 0. Though we do not
80
explicitly write the lim
T0
out.
i. Intercept
Using (3.13)-(3.14), the near-expiry at-the-money implied volatility of the displaced
Heston is:
(
DH
imp
(S))
2
= (
H
imp
(S
0
)(1/S
0
))
2
= (
2
0
+(
2
0
)
T
2
2
T
12
)(1/S
0
)
2
+O(T
2
).
(B.19)
ii. Slope
DH
imp
(K)
K
|
K=S
0
= lim
KS
0
DH
imp
(K)
DH
imp
(S
0
)
K S
0
= lim
KS
0
H
imp
(K )
log(S
0
/K)
log((S
0
)/(K))

H
imp
(S
0
)(1 /S
0
)
K S
0
= lim
KS
0
H
imp
(K )
K
log(S
0
/K)
log((S
0
)/(K ))
+
H
imp
(K )
1
K
log((S
0
)/(K )) +
1
K
log(S
0
/K)
(log((S
0
)/(K )))
2
(LHopitals rule)
= lim
KS
0
H
imp
(K )
K
(1 /S
0
) +
H
imp
(S
0
)

2S
2
0
where in the last step we use
lim
KS
0
log(S
0
/K)
log((S
0
)/(K ))
= 1 /S
0
and
lim
KS
0
1
K
log((S
0
)/(K )) +
1
K
log(S
0
/K)
(log((S
0
)/(K )))
2
=

2S
2
0
.
Applying (B.17) for the Heston model, we have,
H
imp
(

K)
K=
S
0
=
1
2
(
H
imp
(

K))
1
_
a
0
1
K
c
0
log(
S
0
/

K)
1
K
_
K=
S
0
= 0 + O(T).
(B.20)
81
So
DH
imp
(K)
K
|
K=S
0
=
H
imp
(S
0
)

2S
2
0
+ O(T). (B.21)
Consequently the slope is
log
DH
imp
(K)
log K
K=S
0
=

2(S
0
)
+ O(T). (B.22)
iii. Convexity
For the second derivative, using (3.14), we have
DH
imp
(K)
K
2
=
H
imp
(K )
K
2
log(
S
0
K
)
log(
S
0
K
)
+ 2
H
imp
(K )
K
K
_
log(
S
0
K
)
log(
S
0
K
)
_
+
H
imp
(K )

2
K
2
_
log(
S
0
K
)
log(
S
0
K
)
_
.
Using
H
imp
(K)
K
K=S
0
= O(T) in (B.20), we only need to calculate the rst and
third term. The rst term is straightforward to calculate, and the third term requires
more attention.
(a) The rst term
Combining
lim
KS
0
H
imp
(

K)

K
2
=
1
2
_
H
imp
(S
0
)
_
1
c
0
(S
0
)
2
and lim
KS
0
log(
S
0
K
)
log(
S
0
K
)
=
S
0
S
0
,
we have
lim
KS
0
H
imp
(K )
K
2
log(
S
0
K
)
log(
S
0
K
)
=
1
2
_
H
imp
(S
0
)
_
1
c
0
(S
0
)S
0
. (B.23)
(b) The third term
82
With some calculation, we have
H(S
0
, ) := lim
KS
0
2
K
2
_
log(
S
0
K
)
log(
S
0
K
)
_
=
4
2
5S
0
6S
3
0
(S
0
)
.
lim
KS
0
H
imp
(K )

2
K
2
_
log(
S
0
K
)
log(
S
0
K
)
_
=
H
imp
(S
0
)H(S
0
, ). (B.24)
Combining (B.23) and (B.24) gives the second derivative of the implied volatility
DH
imp
(K)
K
2
K=S
0
=
1
2
_
H
imp
(S
0
)
_
1
c
0
(S
0
)S
0
+
H
imp
(S
0
)H(S
0
, )+O(T).
(B.25)
Proof of Proposition 3.2.1. We will use the relationship between the implied volatilities of
the displaced anti -Heston model and the Heston model. Other parts of the proof are similar
to those in Proposition 3.1.2. Denote

K = K and

S = S
0
.
i. Intercept:
The short-expiry at-the-money implied volatility is easy to get:
(
ADH
imp
(S
0
))
2
= (
H
imp
(S
0
)(1/S
0
))
2
= (
2
0
+(
2
0
)
T
2
2
T
12
)(1/S
0
)
2
+O(T
2
).
(B.26)
ii. Slope
The rst derivative
DH
imp
(K)
K
is calculated as in the case of displaced Heston, which is
ADH
imp
(K)
K
K=S
0
=
H
imp
( S
0
)

2S
2
0
+ O(T). (B.27)
Consequently, we have
log
ADH
imp
(K)
log K
K=S
0
=

2(S
0
)
+ O(T). (B.28)
iii. Convexity
83
Use (3.14), we have
ADH
imp
(K)
K
2
=
_
H
imp
( K)
K
2
log(
S
0
K
)
log(
S
0
K
)
+ 2
H
imp
( K)
K
K
_
log(
S
0
K
)
log(
S
0
K
)
_
+
H
imp
( K)

2
K
2
_
log(
S
0
K
)
log(
S
0
K
)
__
.
Again since
H
imp
(K)
K
K=S
0
= O(T), we only need to calculate the rst and the
third term.
(a) The rst term
Combining
lim
KS
0
H
imp
(

K)

K
2
=
1
2
_
H
imp
(S
0
)
_
1
c
0
( S
0
)
2
and lim
KS
0
log(
S
0
K
)
log(
S
0
K
)
=
S
0
S
0
,
we have
lim
KS
0
H
imp
( K)
K
2
log(
S
0
K
)
log(
S
0
K
)
=
1
2
_
H
imp
( S
0
)
_
1
c
0
(S
0
)S
0
. (B.29)
(b) The third term
This is exactly the same as in the displaced Heston case:
lim
KS
0
H
imp
( K)

2
K
2
_
log(
S
0
K
)
log(
S
0
K
)
_
=
H
imp
( S
0
)H(S
0
, ). (B.30)
Combing (B.29) and (B.30) gives the convexity as
ADH
imp
(K)
K
2
K=S
0
=
1
2
_
H
imp
(S
0
)
_
1
c
0
(S
0
)S
0
H
imp
(S
0
)H(S
0
, )+O(T).
(B.31)
84
APPENDIX C
C.1 Appendix: Proof of Theorem 12Partial Strong
Convergency of Stochastic Volatility Process
Proof. The proof here has the same avor as the proof of Theorem 1 in Zhang et al (2004),
except for two major dierences:
1. In Zhang et al(2004) Theorem 1, their stopping time is = where = inf{t
0 : S
t
t
/
1
}, = inf{t 0 : S
t
/
1
}. We add one more piece to the stopping
time , which is = , where = inf{t 0 :
t
/
2
}.
2. We substitute the local Lipschitz condition (*) with their local Lipschitz condition
(15).
To make it complete, we sketch the outline of the proof below.
First, we can write a continuous version of the Euler approximation dened in (6.6) as
follows.
S
t
t
= S
0
+
_
t
0
A(u,

S
t
u
,
t
u
)du +
_
t
0
B(u,

S
t
u
,
t
u
)dW
u
, (C.1)
where we introduce the piecewise constant process
S
t
t
= S
t
t
n
, for t [t
n
, t
n+1
),

t
t
=
t
t
n
, for t [t
n
, t
n+1
).
(C.2)
Note that S
t
t
and

S
t
t
coincide at the discrete points t
n
= nt.
Let T
1
[0, T] be an arbitrary time. For any t [0, T
1
], we have
E
_
sup
0tT
1
|S
t
t
S
t
|
2
_
2E sup
0tT
1
_
t
0
(A(u,

S
t
u
,
t
u
) A(u, S
u
,
u
))du
2
+ 2E sup
0tT
1
_
t
0
(B(u,

S
t
u
,
t
u
) B(u, S
u
,
u
))dW
u
2
.
(C.3)
85
Applying the Holder inequality to the rst term of (C.3) gives
2E sup
0tT
1
_
t
0
(A(u,

S
t
u
,
t
u
) A(u, S
u
,
u
))du
2
2TE sup
0tT
1
_
T
1
0
(A(u,

S
t
u
,
t
u
) A(u, S
u
,
u
))
2
du.
(C.4)
Applying the Doob inequality to the second term of (C.3) gives
2E sup
0tT
1
_
t
0
(B(u,

S
t
u
,
t
u
) B(u, S
u
,
u
))du
2
8C
1
E sup
0tT
1
_
T
1
0
(B(u,

S
t
u
,
t
u
) B(u, S
u
,
u
))
2
du.
(C.5)
If A(.) and B(.) satisfy the local Lipschitz condition (*), we have
|(A(u,

S
t
u
,
t
u
) A(u, S
u
,
u
))|
2
|(B(u,

S
t
u
,
t
u
) B(u, S
u
,
u
))|
2
K
1
(
1
2
)|
S
t
u
S
u
|
2
+ K
2
(
1
2
)|
t
u

u
|
2
.
(C.6)
Substituting (C.4)-(C.6) into (C.3) and use condition (6.11), we have
E
_
sup
0tT
1
|S
t
t
S
t
|
2
_
2(T + 4C
1
)K
1
(
1
2
)E
_
T
1
0
|
S
t
u
S
u
|
2
du + K
4
(
1
2
)t
= 2(T + 4C
1
)K
1
(
1
2
)E
_
T
1
0
|
S
t
u
S
t
u
+ S
t
u
S
u
|
2
du
+K
4
(
1
2
)t
4(T + 4C
1
)K
1
(
1
2
)E
_
T
1
0
(|
S
t
u
S
t
u
|
2
+|S
t
u
S
u
|
2
)du
+K
4
(
1
2
)t
4(T + 4C
1
)K
1
(
1
2
)E
_
T
1
0
|
S
t
u
S
t
u
|
2
du + K
4
(
1
2
)t
+4(T + 4C
1
)K
1
(
1
2
)
_
T
1
0
E
_
sup
0u
u
|S
t
u
S
u
|
2
_
du,
(C.7)
where K
4
(
1
2
) = 2(T + 4C
1
)K
2
(
1
2
)D(
2
)T.
86
If the sum of the rst term and the second term on the right-hand side is bounded, then we
could apply the Gronwall inequality which leads to a bound on E
_
sup
0tT
1
|S
t
t
S
t
|
2
_
.
So all we need to prove now is the rst term on the right-hand side is bounded. By the
denition of

S
t
t
, we know that

S
t
t
= S
t
[t/t]t
, where [t/t] is the integer part of t/t.
Use (C.1), we have
E|
S
t
t
S
t
t
|
2
= E|S
t
[t/t]t
S
t
t
|
2
= E
_
_
[t/t]t
0
A(u,

S
t
u
,
t
u
)du
_
t
0
A(u,

S
t
u
,
t
u
)du
+
_
[t/t]t
0
B(u,

S
t
u
,
t
u
)dW
u
_
t
0
B(u,

S
t
u
,
t
u
)dW
u
2
_
2E
_
_
t
[t/t]t
A(u,

S
t
u
,
t
u
)du
2
+
_
t
[t/t]t
B(u,

S
t
u
,
t
u
)dW
u
2
_
.
(C.8)
Applying (6.10) to the rst term on the right-hand side and using the Holder inequality leads
to
_
t
[t/t]t
A(u,

S
t
u
,
t
u
)du
2
K
3
(
1
2
)t
2
. (C.9)
Applying (6.10) to the second term on the right-hand side and using the Ito isometry
(E(
_
t
0
f(X
u
)dW
u
)
2
=
_
t
0
Ef
2
(X
u
)du) leads to
E
_
t
[t/t]t
B(u,

S
t
u
,
t
u
)dW
u
2
K
3
(
1
2
)t. (C.10)
If Tt < 1, (C.9) and (C.10) leads to
E|
S
t
t
S
t
t
|
2
2K
3
(
1
2
)t
2
+ 2K
3
(
1
2
)t. (C.11)
Thus
E
_
tT
1
0
|
S
t
u
S
t
u
|
2
du 2T
1
K
3
(
1
2
)t
2
+ 2T
1
K
3
(
1
2
)t = C
0
(
1
2
)t,
(C.12)
87
where C
0
(
1
2
) = 2K
3
(
1
2
)(1 + T
1
)t. Plugging (C.12) into (C.7), we have
E
_
sup
0tT
1
|S
t
t
S
t
|
2
_
C
1
(
1
2
)t+C
2
(
1
2
)E
_
T
1
O
E
_
sup
0u
u
|S
t
u
S
u
|
2
_
du
(C.13)
where C
1
(
1
2
) = C
0
(
1
2
)4(T +4C
1
)K
1
(
1
2
) +K
4
(
1
2
), C
2
(
1
2
) =
4(T + 4C
1
)K
1
(
1
2
). Now applying the Gronwall inequality to (C.13), we have
E
_
sup
0tT
|S
t
t
S
t
|
2
_
C
1
(
1
2
)e
C
2
(
1
2
)T
t = C(
1
2
)t. (C.14)
Hence the claim is proved.
C.2 Appendix: Coecients of SABR Satisfy the Local Lipschtiz
Condition (*)
The
t
of the SABR process can be simulated exactly, so
t
t
n
=
t
n
. Using this, we have
t
S
t

t
t
(
S
t
t
)
2
=
t
S
t

t
t
n
(S
t
t
n
)
2
=
t
S
t

t
n
(S
t
t
n
)
2
=
t
S
t

t
(S
t
t
n
)
+
t
(S
t
t
n
)
t
n
(S
t
t
n
)
2
2
t
S
t

t
(S
t
t
n
)
2
+ 2
t
(S
t
t
n
)
t
n
(S
t
t
n
)
2
= 2
2
t
_
S
t
(S
t
t
n
)
_
2
+ 2(
t
t
n
)
2
(S
t
t
n
)
2
.
(C.15)
When
1
is bounded compact set and does not contain 0, for any x, y
1
there z (x, y),
such that
(x
)
2
= (z
1
)
2
(x y)
2
C(
1
)(x y)
2
. (C.16)
Thus when
1
,
2
are bounded, B(t, S
t
,
t
) =
t
S
t
satises the local Lipschitz condition
(*).
We can show that the coecients of the logarithm of the SABR process satisfy the local
Lipschitz condition (*) in a similar way.
88
C.3 Appendix: Proof of Proposition 6.2.2 and Theorem
13Strong Convergence of Mean-reverting CEV Process
Proof of Proposition 6.2.2. Equation (6.16) gives the recursive relationship of the second
moment of V
t
n
:
E(V
t
n+1
)
2
= (1t)
2
E(V
t
n
)
2
+2t(1t)EV
t
n
+
2
t
2
2
+
2
tE|V
t
n
|
2
. (C.17)
For < 1, the Holder inequality gives
(E|V
t
n
|
2
)
1
2
(E|V
t
n
|
2
)
1
2
E|V
t
n
|
2
(E|V
t
n
|
2
)
. (C.18)
Plugging the EV
t
n
from (6.17) into (C.17) and use (C.18), we have
E(V
t
n+1
)
2
(1t)
2
E(V
t
n
)
2
+2t(1t)
_
(1t)
n
(EV
t
0
)+
_
+
2
t
2
2
+
2
t(E(V
t
n
)
2
)
.
(C.19)
When 0 < < 1, f(x) = x
is a concave function; so x, the tangent line of f(x) is above

itself. Thus we can choose the tangent line of f(x) which pass the point (1, 1) as
g(x) = (x 1) + 1,
such that x
< (x 1) + 1. Let Z
0
= E(V
t
0
)
2
and Z
n
evolves by the following schemes:
Z
n+1
= (1t)
2
Z
n
+2t(1t)
_
(1t)
n
(EV
t
0
)+
_
+
2
t
2
2
+
2
t
_
(Z
n
1)+1
_
,
(C.20)
The Z
n
derived in this way will be bigger than E(V
t
n
)
2
for all n > 1.
Simplify the notation and write Z
n
as:
Z
n+1
= aZ
n
+ b + cr
n
, (C.21)
where
a = (1 t)
2
+
2
t, b = 2t
2
(1 t) +
2
t
2
2
+ (1 )
2
t,
c = 2t(1 t)E(V
t
0
).
(C.22)
89
It is well established that if |a| < 1, |r| < 1, then
lim
n
Z
n
=
b
1 a
. (C.23)
So when |(1 t)
2
+
2
t| < 1 and |1 t| < 1, the limit of Z
n
exists, therefore the
Z
n
will be bounded and E(V
t
n
)
2
will be bounded.
Proof of Theorem 13. The proof is in similar spirit to the ones in Higham and Mao (2004).
We use a
k
,
k
,
k
as dened by them:
1. a
0
= 1, a
k
= e
k(k+1)/2
.
2. For each k 1,
k
() is a continuous function with support in (a
k
, a
k1
) such that
0
k
()
2
k
, for a
k
< < a
k1
. Also we have
_
a
k1
a
k
k
()d = 1.
3.
k
(x) :=
_
|x|
0
dy
_
y
0

k
()d. Three properties of
k
(x) will be used:
(a)
|
k
(x)| 1. (C.24)
(b)
|
k
(x)|
_
2
k|x|
, for a
k
< |x| < a
k1
= 0, otherwise
(C.25)
(c)
|x| a
k1

k
(x) |x|, for all x R. (C.26)
First, we denote a continuous version of the Euler approximation (6.16) as
V
t
t
:= V
0
+
_
t
0
(

V
t
u
)du +
_
t
0
|
V
t
u
|
dW
u
(C.27)
where we introduce the piecewise constant process
V
t
t
:= V
t
t
n
, for t [t
n
, t
n+1
). (C.28)
Using (C.27), we have
V
t
V
t
t
=
_
t
0
(V
u

V
t
u
)du +
_
t
0
(|V
u
|
V
t
u
|
)dW
u
. (C.29)
90
Applying Itos rule to
k
(V
u
V
t
u
):
d
k
(V
u
V
t
u
) =
k
(V
u
V
t
u
)d(V
u
V
t
u
) +
1
2
k
(V
u
V
t
u
)(d(V
u
V
t
u
))
2
. (C.30)
Plugging (C.29) into (C.30), we have
k
(V
t
V
t
t
) =
_
t
0
k
(V
u
V
t
u
)()(V
u

V
t
u
)du +
_
t
0
k
(V
u
V
t
u
)(|V
u
|
V
t
u
|
)dW
u
+

2
2
_
t
0
k
(V
u
V
t
u
)(|V
u
|
V
t
u
|
)
2
du.
(C.31)
Taking the expectation of both sides gives
E
k
(V
t
V
t
t
) = E
_
t
0
k
(V
u
V
t
u
)(V
u

V
t
u
)du +

2
2
E
_
t
0
k
(V
u
V
t
u
)(|V
u
|
V
t
u
|
)
2
du

_
t
0
E|(V
u

V
t
u
)|du +

2
2
I(t),
(C.32)
where the rst inequality comes from using (C.24), and
I(t) = E
_
t
0
k
(V
u
V
t
u
)(|V
u
|
V
t
u
|
)
2
du
E
_
t
0
k
(V
u
V
t
u
)C()|V
u

V
t
u
|
2
du
= E
_
t
0
k
(V
u
V
t
u
)C()|V
u
V
t
u
+ V
t
u

V
t
u
|
2
du
E
_
t
0
k
(V
u
V
t
u
)C()C(2)(|V
u
V
t
u
|
2
+|V
t
u

V
t
u
|
2
)du
= C
_
E
_
t
0
k
(V
u
V
t
u
)|V
u
V
t
u
|
2
du +
_
t
0
k
(V
u
V
t
u
)|V
t
u

V
t
u
|
2
du
_
CE
_
t
0
2
k
1
(a
k
<|V
u
V
t
u
|<a
k1
)
|V
u
V
t
u
|
21
du + CE
_
t
0
2
ka
k
|V
t
u

V
t
u
|
2
du
C
2T
k
+ C
_
t
0
2
ka
k
E|V
t
u

V
t
u
|
2
du
C
2T
k
+ C
2T
ka
k
(tD)
,
91
where the rst and second inequality use |x + y|
C(|x|
+ |y|
) as proved in Lemma
C.3.1; the second to last and third to last inequality uses (C.25) and the last inequality use
Lemma C.3.2.
Plugging the above results into (C.32), we have
E
k
(V
t
V
t
t
)
_
t
0
E|V
u
V
t
u
|du +
_
t
0
E|V
t
u

V
t
u
|du + C
2
T
k
+ C
2
T
ka
k
(tD)

_
t
0
E|V
u
V
t
u
|du + (tD)
1/2
+ C
2
T
k
+ C
2
T
ka
k
(tD)
,
where the second inequality uses Lemma C.3.2 again. Combining this with the left-hand
side of (C.26) gives
E|V
t
V
t
t
| a
k1
+C
2
T
k
+C
2
T
ka
k
(tD)
+(tD)
1/2
+
_
t
0
E(V
t
V
t
t
)du. (C.33)
Applying the Gronwalls inequality to (C.33) gives the upper bound for E|V
t
V
t
t
|,
sup
0tT
E|V
t
V
t
t
| e
T
_
a
k
+ C
2
T
k
+ C
2
T
ka
k
(tD)
+ (tD)
1/2
_
. (C.34)
The terms in the parenthesis went to 0 as t 0. This proves (6.22).
Lemma C.3.1. > 0, there is a constant C(), such that X, Y ,
|X + Y |
C()(|X|
+|Y |
). (C.35)
Proof. Note that
|X + Y | |X| +|Y | > 0, |X + Y |
(|X| +|Y |)
.
So if we can show
1
C()
(
|X|
|X|+|Y |
)
+ (
|Y |
|X|+|Y |
)
, we are done. Let p =

|X|
|X|+|Y |
, then
1 p =
|Y |
|X|+|Y |
. The function f(p) = p
+(1 p)
is continuous on the interval [0, 1], so it

can achieve the minimum. Moreover, the minimum is bigger than 0. So there is C() such
that the inequality holds.
92
Lemma C.3.2. Under conditions A and B, for t [t
k
, t
k+1
), there is a constant D such
that
E|V
t
t

V
t
t
|
2
(tD)
, (C.36)
E|V
t
t

V
t
t
|
tD. (C.37)
Proof. When < 1, the Holder inequality gives
E|V
t
t

V
t
t
|
2
(E|V
t
t

V
t
t
|
2
)
, (C.38)
so it is enough to show that there is a constant D such that E(V
t
t

V
t
t
)
2
tD.
From (C.27), we have
(V
t
t

V
t
t
)
2
=
_
(t t
k
)( V
t
k
) + |V
t
k
|
(W
t
W
t
k
)
_
2
= (t t
k
)
2
2
( V
t
k
)
2
+
2
|V
t
k
|
2
(W
t
W
t
k
)
2
+2(t t
k
)( V
t
k
)|V
t
k
|
(W
t
W
t
k
).
Taking the expectation of both sides gives
E(V
t
t

V
t
t
)
2
= (t t
k
)
2
2
E( V
t
k
)
2
+
2
(t t
k
)E|V
t
k
|
2
t
2
2
E( S
k
)
2
+
2
tE|S
k
|
2
= t
_
t(
2
2ES
k
+ES
2
k
) +
2
E|S
k
|
2
_
t
_
(
2
2ES
k
+ES
2
k
) +
2
E|S
k
|
2
_
tD
where the last inequality uses Proposition 6.2.2. Combining with (C.38), we have
E|V
t
t

V
t
t
|
2
(tD)
.
Finally, E|V
t
t

V
t
t
| (E(V
t
t

V
t
t
)
2
)
1
2

tD.
93
APPENDIX D
D.1 Appendix: Proof of Theorem 14 Large-strike and
Large-expiry Asymptotic of Displaced Lognormal
Lemma D.1.1. For A dened in (7.3), T K
x
, dene
(x, T) :=
_
_
_
2(2A + x 2
A
2
+ Ax) if x R/[
1
2
2
,
1
2
2
]
2(2A + x + 2
A
2
+ Ax) if x [
1
2
2
,
1
2
2
]
(D.1)
we have
1
2
(x, T)
_
_
x if x >
1
2
2
x if x [0,
1
2
2
]
(x) if x [
1
2
2
, 0]
(x) if x <
1
2
2
(D.2)
For each x, the equalities in the rst and last equation in (D.2) hold only at most nite T,
so for T large enough, the strict inequalities hold and we have
1
2
(x, T)
_
_
< x if x >
1
2
2
< (x) if x <
1
2
2
(D.3)
Proof. We suppress the T in
2
(x, T) to be
2
(x). Note that

2
(x) dened in (D.1) is in

fact the solution of the function
A =
(x +
(x)
2
/2)
2
2
(x)
2
. (D.4)
Denote
V
BS
(x, ) =
(x +
2
/2)
2
2
2
, (D.5)
94
then A = V
BS
( x, ) x and (D.4) can be written as
V
BS
( x, ) x = V
BS
(x,
(x)) x. (D.6)
When x R/[
1
2
2
,
1
2
2
], we choose
(x) to be the smaller root which satises (D.4),

so
(x) = 2(2A + x 2
_
A
2
+ Ax). (D.7)
If x >
1
2
2
> 0, using A =
( x+
2
/2)
2
2
2
0, we have
1
2
(x) x = 2A 2
_
A
2
+ Ax 0. (D.8)
The equality holds if and only if x =
2
/2, which happens at most at one T. If x <
1
2
2
< 0,
using A + x =
(x+
2
/2)
2
2
2
0 and 0 A + x < A, we have

1
2
(x) (x) = 2(A + x) 2

_
A
2
+ Ax 0. (D.9)
The equality hold if and only if A+x =
( x+
2
/2)
2
2
+x = 0, which again, happens at most
at two Ts.
When x [
1
2
2
,
1
2
2
], we choose
(x) to be the larger root which satises (D.4), so
(x) = 2(2A + x + 2
_
A
2
+ Ax). (D.10)
If 0 x
1
2
2
, using A 0 gives
1
2
(x) x = 2A + 2
_
A
2
+ Ax 0. (D.11)
If
1
2
2
x < 0, using A + x 0 gives
1
2
(x) (x) = 2(A + x) + 2

_
A
2
+ Ax 0. (D.12)
Proof. [Proof of Theorem 14.]
95
We rst show the case when x >
2
/2. For S from displaced lognormal dynamics, denote
S = S , then

S will be a lognormal process and
1
S
0
E(
S
T

S
0
e
xT
)
+
= N(z
+
) e
xT
N(z
), (D.13)
where z
=
( x
2
/2)
.
Recall an approximation of the cumulative density function of standard normal N(z)
from Olver(1974):
N(z) = 1 N(z) =
exp(z
2
/2)
z
2
(1 + O(1/z
2
)), as z +. (D.14)
When x >
2
/2, there is a T
0
such that when T > T
0
, x >
2
/2. Then as T , we
have z
. Using (D.14) and A

BS
in (7.7), we have
N(z
+
) e
xT
N(z
) =
1
2T
e
1
2
(
x
2
2
x+
2
4
)T
_

x
2
/2

x +
2
/2
_
(1 + O(
1
T
))
=
1
2T
e
( x
2
/2)
2
2
2
T
A
BS
( x, , 0)(1 + O(
1
T
))
=
1
2T
e
(V
BS
( x,) x)T
A
BS
( x, , 0)(1 + O(
1
T
)).
(D.15)
Consequently,
1
S
0
E(S
T
S
0
e
xT
)
+
=
S
0
S
0
1
S
0
E(
S
T

S
0
e
xT
)
+
=
S
0
S
0
1
2T
e
(V
BS
( x,) x)T
A
BS
( x, , 0)(1 + O(
1
T
)).
(D.16)
We choose
(x) and a
1
so that
V
BS
( x, ) x = V
BS
(x,
(x)) x, (D.17)
S
0
S
0
A
BS
( x, , 0) = A
BS
(x,
(x), a
1
(x)). (D.18)
96
Plugging (D.17) and (D.18) into (D.16), we have
1
S
0
E(S
T
S
0
e
xT
)
+
=
1
2T
e
(V
BS
(x,
(x))x)T
A
BS
(x,
(x), a
1
(x))(1+O(
1
T
)). (D.19)
Now if we could show that x + (
(x)
2
+ a
1
(x)/T)/2 > 0 for large enough T, then we
could apply (D.14) to show that (D.19) is an asymptotic formula for the Black-Scholes call
price with volatility
_
(x) + a
1
(x)/T.
Denote
2
T
=
2
(x)+
a
1
(x)
T
. By Lemma D.1.1 we know that x >
2
(x)/2. lim
T
a
1
(x)
converges to a constant. So for T large enough, we have x >
2
T
/2. Using (D.14), the Black-
Scholes call price formula can be approximated as
C
BS
(S
0
, S
0
e
xT
,
T
, T) =
1
2T
exp
_
1
2
(
x
2

2
T
x +

2
T
4
)T
__

T
x
2
T
/2

T
x +
2
T
/2
_
(1 + O(1/T))
=
1
2T
e
(V
BS
(x,
(x))x)T
A
BS
(x,
(x), a
1
(x))(1 + O(
1
T
)).
(D.20)
Intuitively, comparing (D.19) and (D.20), we can see that the implied volatility of the
displaced lognormal process is
2
imp
(x, T) =
2
(x) + a
1
(x)/T + o(1/T). (D.21)
The rigorous proof is as follows. From (D.19), > 0,
1
S
0
E(S
T
S
0
e
xT
)
+
=
A
BS
(x,
, a
1
)
2T
exp((V
BS
(x,
) x)T)(1 + O(1/T)) (D.22)
A
BS
(x,
, a
1
)
2T
exp((V
BS
(x,
) x)T)e
. (D.23)
For any > 0, Lemma D.1.1 shows that () = (
4x
2
(x)
1)

16
> 0. Thus, we can choose
> 0 in the previous step so that () < 0, and
exp
_
1
8
a
1
(x)(
4x
2
1) +
_
exp
_
1
8
( a
1
(x) + )(
4x
2
1) + ()
_
.
97
Using (D.23) and (D.20), > 0, there exists T
1
, such that when T > T
1
,
1
S
0
E(S
T
S
0
e
xT
)
+
A
BS
(x,
, a
1
+ )
2T
exp
_
(V
BS
(x,
) x)T + ()
_
C
BS
(S
0
, S
0
e
xT
,
2
(x) + ( a
1
(x) + )/T, T)
Using the monotonicity of the Black-Scholes formula, the implied volatility of the displaced
lognormal process
imp
(x) is
2
imp
(x, T)
2
(x) + ( a
1
(x) + )/T.
Similarly, we can prove the lower bound, so the equality in (7.5) holds.
For the x <
2
/2 case, we consider the put price on the displaced lognormal dynamics,
and apply similar methods.
D.2 Appendix: Proof of Theorem 15First Order Approximation
of Large-strike Large-expiry Implied Volatility
Lemma D.2.1. For x (
2
/2,
2
/2), we have
lim
T
E(S
T
S
0
e
xT
)
+
= S
0
. (D.24)
Proof. Apply the asymptotic approximation of N(.) to get the results. More specically,
1
S
0
E(S
T
S
0
e
xT
)
+
=
S
0
S
0
1
S
0
E(
S
T

S
0
e
xT
)
+
=
S
0
S
0
_
1 +
1
2T
e
1
2
(
x
2
2
x+
2
4
)T
_

x
2
/2

x +
2
/2
_
(1 + O(
1
T
))
_
= 1

S
0
+
S
0
S
0
1
2T
e
1
2
(
x
2
2
x+
2
4
)T
_

x
2
/2

x +
2
/2
_
(1 + O(
1
T
))
(D.25)
Proof. [Proof of Theorem 15.]
98
When < 0, lim
T
E(S
0
S
0
e
xT
) = S
0
> S
0
, so
imp
(T) is not well dened when
T is large.
When > 0, denote B := N
1
(
S
0
S
0
). Dene (T) as
(T) :=
B +
B
2
+ 2xT
T
.
Abbreviate (T) as , it satises the equation:
x +
2
/2

T = B, (D.26)
and lim
T
(x
2
/2)
T

= lim
T
B
2
+ 2xT = . So
lim
T
C
BS
(S
0
, S
0
e
xT
, , T) = lim
T
S
0
N
_
(x +
2
/2)
T

_
S
0
e
xT
N
_
(x
2
/2)
T

_
= S
0
.
(D.27)
Recall that lim
T
C
BS
(S
0
, S
0
e
xT
,
imp
(T)) = S
0
, so
lim
T
imp
(x, T) = lim
T
(T) = 2x. (D.28)
D.3 Appendix: Proof of Theorem 16Asymptotic Formula of
Black-Scholes Call Option
Proof.
1
S
0
C
BS
(S
0
, S
0
e
xT
,
2x + 2B
_
2x
T
+
a(T)
T
, T)
=
_
N
_
(B
_
2x
T
+
a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
N(B)
_
+ N(B) e
xT
N
_
(2x B
_
2x
T

a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
(D.29)
99
Applying Taylor expansion to the rst term, we have
N
_
(B
_
2x
T
+
a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
N(B)
=
1
2T
exp
_
1
2
_
(B
_
2x
T
+
a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
2
__
(B
_
2x
T
+
a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
B
_
T(1 + O(
1
T
))
=
1
2T
exp(
1
2
B
2
)
a(T)/2 B
2
2x
(1 + O(1/
T)).
(D.30)
For the last term, using (D.14) gives
e
xT
N
_
(2x B
_
2x
T

a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
=
1
2T
exp
_
1
2
_
(B
_
2x
T
+
a(T)
2T
)
T
_
2x + 2B
_
2x
T
+
a(T)
T
_
2
_
_
2x + 2B
_
2x
T
+
a(T)
T
2x + B
_
2x/T +
a(T)
2T
(1 + O(
1
T
)
=
1
2T
exp(
1
2
B
2
)
1
2x
(1 + O(1/
T)).
(D.31)
Plugging (D.30) and (D.31) into (D.29), we have
1
S
0
C
BS
(S
0
, S
0
e
xT
,
2x + 2B
_
2x
T
+
a(T)
T
, T)
= N(B) +
1
2T
e
1
2
B
2 1
2x
(a(T)/2 B
2
1)(1 + O(1/
T)).
(D.32)
100
D.4 Appendix: Proof of Theorems 17 and 18 Second and Third
Order Approximation of Large-strike Large-expiry Implied
Volatility
Proof of Theorem 17. Using (D.25) and the denition of a(T) and B, we have > 0,
1
S
0
E(S
T
S
0
e
xT
)
+
= 1

S
0
+
S
0
S
0
1
2T
e
1
2
(
x
2
2
x+
2
4
)T
_

x
2
/2

x +
2
/2
_
(1 + O(
1
T
))
1

S
0
+
S
0
S
0
1
2T
e
1
2
(
x
2
2
x+
2
4
)T
_

x
2
/2

x +
2
/2
_
e
= N(B) +
1
2T
exp(
1
2
B
2
)
1
2x
(a(T)/2 B
2
1)e
(D.33)
From the denition of a(T), we know that a(T) > B
2
+ 1. > 0, > 0, there () > 0,
such that T
0
, T > T
0
(a(T)/2 B
2
1)e
< ((a(T) + )/2 B

2
1)e
()
. (D.34)
Using (D.33), (D.34) and proposition 16, we have
1
S
0
E(S
T
S
0
e
xT
)
+
N(B) +
1
2T
exp(
1
2
B
2
)
1
2x
(a(T)/2 B
2
1)e
N(B) +
1
2T
exp(
1
2
B
2
)
1
2x
((a(T) + )/2 B
2
1)e
()
1
S
0
C
BS
(S
0
, S
0
e
xT
,
2x + 2B
_
2x
T
+
a(T) +
T
, T).
(D.35)
So
2
imp
(x, T) 2x + 2B
_
2x
T
+
a(T) +
T
.
Similarly, we can show that
2
imp
(x, T) 2x + 2B
_
2x
T
+
a(T)
T
.
101
This completes the proof.
Proof of Theorem 18. Similar to the proof of Theorem 17.
D.5 Appendix: Proof of Theorem 19Large-strike Large-expiry
At-the-money Implied Volatility
Proof. Suppress the 0 in
imp
(0, T) to be
imp
(T). When at-the-money, for the displaced
lognormal, we have
C
BS
(S
0
, S
0
e
xT
,
imp
(T), T) = S
0
(2N(
imp
T/2) 1),
On the other hand, S is lognormal process, so
E(S
T
K)
+
= E((S
T
) (K ))
+
= (S
0
)(2N(
T/2) 1).
So
S
0
(2N(
imp
T/2) 1) = (S
0
)(2N(
T/2) 1),
N(
imp
(T)
T/2) =
S
0
S
0
N(
T/2) +

S
0
;

imp
(T) =
2
T
N
1
_
S
0
S
0
N(
T/2) +

2S
0
_
.
Taking the limit of T, we have (7.14).
D.6 Appendix: Proof of Theorem 20Approximation of Implied
Volatility when K = S
0
exp(xT
)
Proof. Here we sketch the outline of the proof. The rigorous proof is similar to the proof of
Theorem 17. We prove the x > 0 case. Denote x =
1
T
log(
S
0
e
xT
S
0
), M = xT
1
,

M =
xT
1
and A =
_

M+
2
/2
_
2
.
2
satises
_
M+
2
/2
_
2
=
_

M+
2
/2
_
2
. Choose the
smaller root
2
= 2(M + A)
2MA + A
2
so that

2
2
M < 0. Abbreviate
imp
(x, T)
102
to be
imp
. Using the approximation of N(.), we have
1
S
0
E(S
T
S
0
e
xT
)
+
=
S
0
S
0
1
S
0
E(
S
T

S
0
e
xT
)
+
=
S
0
S
0
_
N
_
( xT
1
+
2
/2)
_
e
xT
N
_
( xT
1
2
/2)
__
=
S
0
S
0
1
2T
exp
_
1
2
_
xT
1
+
2
/2
_
2
T
__

xT
1
2
/2

xT
1
+
2
/2
_
(1 + o(1/T))
=
S
0
S
0
1
2T
exp
_
1
2
_
M +
2
/2
_
2
T
_
A
BS
(

M, , 0)(1 + o(1/T))
=
1
2T
exp
_
1
2
_
M +
2
/2
_
2
T
_
exp
_
a
8
(
4M
2
) 1
_
A
BS
(M,
, 0)(1 + o(1/T))
=
1
2T
exp
_
1
2
_
M +
2
imp
/2
imp
_
2
T
__

imp
xT
1
2
imp
/2
imp
xT
1
+
2
imp
/2
_
(1 + o(1/T))
1
S
0
C
BS
(S
0
, S
0
e
xT
,
imp
, T).
(D.36)
The x < 0 case can be similarly proved.
D.7 Appendix: Proof of Theorem 21Fixed-strike Large-expiry
Implied Volatility
D.7.1 Asymptotic behavior
Proof. Suppress the x in the
imp
(x, T) to be
imp
(T). On the one hand, we have
lim
T
E(S
T
K)
+
= lim
T
S
0
N
_
log(S
0
/K)
imp
(T)
T
+
imp
(T)
T
2
_
KN
_
log(S
0
/K)
imp
(T)
imp
(T)
T
2
_
.
(D.37)
103
On the other hand,
lim
T
E(S
T
K)
+
= lim
T
E((S
T
) (K ))
+
= lim
T
(S
0
)N(
log((S
0
)/(K )) +
2
T/2
T
)
(K )N(
log((S
0
)/(K ))
2
T/2
T
)
= S
0
.
(D.38)
Comparing (D.37) and (D.38), we know that the limit of
imp
(T)
T exists and satisfy

the following condition
lim
T
S
0
N
_
log(S
0
/K)
imp
(T)
T
+
imp
(T)
T
2
_
KN
_
log(S
0
/K)
imp
(T)
imp
(T)
T
2
_
= S
0
.
(D.39)
Recall the denition of
blsimpv
(S
0
, K, P) in (7.21) is
S
0
N
_
log(S
0
/K)
blsimpv
(S
0
, K, P)
+
blsimpv
(S
0
, K, P)
2
_
KN
_
log(S
0
/K)
blsimpv
(S
0
, K, P)
blsimpv
(S
0
, K, P)
2
_
= P,
(D.40)
comparing (D.39) and (D.40), we have (7.20).
D.7.2 Monotonicity
Proof. Recall the
imp
(T) is dened as follows
C
BS
(S
0
, K,
imp
(T), T) = C
BS
(S
0
, K , , T). (D.41)
Dierentiating both sides with respect to T gives us
C
BS
(S
0
, K,
imp
(T), T)
T
+
C
BS
(S
0
, K,
imp
(T), T)
imp
(T)
imp
(T)
T
=
C
BS
(S
0
, K , )
T
.
(D.42)
104
Using
C
BS
(S
0
,K,
imp
(T),T)
imp
(T)
> 0, we have
sgn
imp
(T)
T
= sgn
_
C
BS
(S
0
, K , )
T

C
BS
(S
0
, K,
imp
(T))
T
_
= sgn
_
(S
0
)N
_
log((S
0
)/(K ))
T
+

T
2
_
S
0
N
_
log(S
0
/K)
imp
(T)
T
+
imp
(T)
T
2
_
imp
(T)
_
= sgn
_
(S
0
) exp
_
1
2
_
log((S
0
)/(K ))
T
+

T
2
_
2
_
S
0
exp
_
1
2
_
log(S
0
/K)
imp
(T)
T
+
imp
(T)
T
2
_
2
_
imp
(T)
_
.
(D.43)
From (D.43), we have
lim
T
sgn
imp
(T)
T
= lim
T
sgn
_
(S
0
) exp
_
1
2
_
log((S
0
)/(K ))
T
+

T
2
_
2
_
T
S
0
exp
_
1
2
_
log(S
0
/K)
imp
(T)
T
+
imp
(T)
T
2
_
2
_
imp
(T)
T
_
= lim
T
sgn
__
K
S
0
_
1/2
exp
_
1
2
2
T
4
_
_
K
S
0
_
1/2
exp
_
1
2
2
imp
T
4
_
imp
(T)
T
_
.
(D.44)
Note that exp
_
1
2
2
T
4
_
T as T is dominated by the exponential term, so the rst

term goes to 0. From Theorem 21.1, lim
T
imp
(T)
T exists, so the second term goes to

some positive constant. Therefore,
lim
T
sgn
imp
(T)
T
< 0.
105
D.8 Appendix: Proof of Theorem 22Approximation of
Fixed-Strike Large-expiry Implied Volatility.
Proof. Denote a =
2
blsimpv
(S
0
,K,S
0
)
2
. From Theorem 21, we know that the rst term of
imp
(x, T) is
blsimpv
(S
0
, K, S
0
)/
T = 2a/T. Here we want a more rened approxima-

tion of the residual term. So denote
2
imp
(x, T) =
2a
T
+ 2r. Denote

S
0
= S
0
and use the
Taylor approximation of N(.) to the second order, we have
1
S
0
E(S
0
K)
+
=
S
0
S
0
+
_
N(
x + a + rT
2a + 2rT
) N(
x + a
2a
)
_
+ e
x
_
N(
x a rT
2a + 2rT
) N(
x a
2a
)
_
=
S
0
S
0
+
1
2
exp(
1
2
(
x + a
2a
)
2
)
__
2a + 2rT
2a
_
+
_
2a + 2rT
2a
_
2
_
x
2
4a(a + rT)
_
_
a + rT
a

1
2
_
1
8
__
+ o((rT)
2
)
(D.45)
Let
2a + 2rT
2a = z, then
1
S
0
E(S
0
K)
+
=
S
0
S
0
+
1
2
exp(
1
2
(
x + a
2a
)
2
)
_
z + z
2
_
x
2
2a(z +
2a)
2
_
z
2a
+
1
2
_
1
8
__
+ o((rT)
2
)
S
0
S
0
+
1
2
exp(
1
2
(
x + a
2a
)
2
)
_
(
1
8
+
x
2
8a
2
)z
2
+ z
_
(D.46)
On the other hand, we have
1
S
0
E(S
0
K)
+
=
1
S
0
C
BS
(S
0
, K , , T) (D.47)
Compare (D.46) with (D.47) and solve for z.
106
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THE UNIVERSITY OF CHICAGO

DISPLACED LOGNORMAL AND DISPLACED HESTON VOLATILITY SKEWS:

are independent Brownian motions, and absorption is imposed at S = 0.

, in contrast to our approach which matches the implied volatility functions.

are independent, we choose Y to be the same payo function applied to

. We choose the S process parameters by taking S

has a simple exact formula, and the control Y

. The DH process parameters

can be calculated analytically under the DL process.

can be calculated analytically. In (5.13), we choose

. in the DL case, (, ) are tuned by (4.9); in the DH case, (

(.) is the density function of N(a

N(0, t), and

T and we restrict the leading term

Theorem 14 can be extended to the region where K approaches such that K = S

for x = 0 and > 1. This is given in Theorem 20.

, we could have a highly accurate approximation of

). Secondly, we give the approximation of the implied

T/2 < log(S

conclusions hold because of

(K) are well-dened.

/K > 0 on K, by Lemma A.1.9. So on K we have H

(K) > 0, hence

(K) by Lemma A.1.7.

T/2) 1], (A.15)

conclusions hold because of

(K) > 0 hence y

T/2) 1], (A.34)

is a concave function; so x, the tangent line of f(x) is above

, we are done. Let p =

is continuous on the interval [0, 1], so it

(x). Note that

(x) dened in (D.1) is in

(x) to be the smaller root which satises (D.4),

0 and 0 A + x < A, we have

(x) (x) = 2(A + x) 2

(x) to be the larger root which satises (D.4), so

(x) (x) = 2(A + x) + 2

. Using (D.14) and A

) x)T)(1 + O(1/T)) (D.22)

< ((a(T) + )/2 B

T exists and satisfy

T as T is dominated by the exponential term, so the rst

T exists, so the second term goes to

T = 2a/T. Here we want a more rened approxima-

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