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Gs Volatility Swaps|Views: 3|Likes: 0

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Research Notes

Goldman

Sac hs

March 1999

More

Than You Ever Wanted To Know

*

About

Volatility Swaps

Kresimir Demeterﬁ

Emanuel Derman

Michael Kamal

Joseph Zou

_____________

* But Less Than Can Be Said

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

-2

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-1

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

SUMMARY

Volat ilit y swaps ar e for war d cont r act s on fut ur e r ealized

st ock volat ilit y. Var iance swaps ar e similar cont r act s on var i-

ance, t he squar e of fut ur e volat ilit y. Bot h of t hese inst r ument s

pr ovide an easy way for invest or s t o gain exposur e t o t he

fut ur e level of volat ilit y.

Unlike a st ock opt ion, whose volat ilit y exposur e is cont ami-

nat ed by it s st ock-pr ice dependence, t hese swaps pr ovide pur e

exposur e t o volat ilit y alone. You can use t hese inst r ument s t o

speculat e on fut ur e volat ilit y levels, t o t r ade t he spr ead

bet ween r ealized and implied volat ilit y, or t o hedge t he vola-

t ilit y exposur e of ot her posit ions or businesses.

In t his r epor t we explain t he pr oper t ies and t he t heor y of bot h

var iance and volat ilit y swaps, ﬁr st fr om an int uit ive point of

view and t hen mor e r igor ously. The t heor y of var iance swaps

is mor e st r aight for war d. We show how a var iance swap can be

t heor et ically r eplicat ed by a hedged por t folio of st andar d

opt ions wit h suit ably chosen st r ikes, as long as st ock pr ices

evolve wit hout jumps. The fair value of t he var iance swap is

t he cost of t he r eplicat ing por t folio. We der ive analyt ic for mu-

las for t heor et ical fair value in t he pr esence of r ealist ic vola-

t ilit y skews. These for mulas can be used t o est imat e swap

values quickly as t he skew changes.

We t hen examine t he modiﬁcat ions t o t hese t heor et ical

r esult s when r ealit y int r udes, for example when some neces-

sar y st r ikes ar e unavailable, or when st ock pr ices under go

jumps. Finally, we br ieﬂy r et ur n t o volat ilit y swaps, and show

t hat t hey can be r eplicat ed by dynamically t r ading t he mor e

st r aight for war d var iance swap. As a r esult , t he value of t he

volat ilit y swap depends on t he volat ilit y of volat ilit y it self.

_________________

Kr esimir Demet er ﬁ (212) 357-4611

Emanuel Der man (212) 902-0129

Michael Kamal (212) 357-3722

J oseph Zou (212) 902-9794

_________________

Acknowledgments: We t hank Emmanuel Boussar d, Llewel-

lyn Connolly, Rust om Khandalavala, Cyr us Pir ast eh, David

Roger s, Emmanuel Roman, Pet er Selman, Richar d Sussman,

Nicholas War r en and sever al of our client s for many discus-

sions and insight ful quest ions about volat ilit y swaps.

_________________

Edit or ial: Bar bar a Dunn

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

0

Table of Contents

INTRODUCTION ......................................................................................... 1

Volat ilit y Swaps ........................................................................... 1

Who Can Use Volat ilit y Swaps? ................................................. 2

Var iance Swaps ............................................................................ 3

Out line .......................................................................................... 4

I. REPLICATING VARIANCE SWAPS: FIRST STEPS...................................... 6

The Int uit ive Appr oach ............................................................... 6

Tr ading Realized Volat ilit y wit h a Log Cont r act ..................... 11

The Vega, Gamma and Thet a of a Log Cont r act ...................... 11

Imper fect Hedges ...................................................................... 13

The Limit at ions of t he Int uit ive Appr oach .............................. 13

II. REPLICATING VARIANCE SWAPS: GENERAL RESULTS ....................... 15

Valuing and Pr icing t he Var iance Swap.................................. 17

III. AN EXAMPLE OF A VARIANCE SWAP ................................................ 20

IV. EFFECTS OF THE VOLATILITY SKEW ................................................ 23

Skew Linear in St r ike ............................................................... 23

Skew Linear in Delt a ................................................................ 25

V. PRACTICAL PROBLEMS WITH REPLICATION ....................................... 27

Imper fect Replicat ion Due t o Limit ed St r ike Range ............... 27

The Effect of J umps on a Per fect ly Replicat ed Log Cont r act .. 29

The Effect of J umps When Replicat ing Wit h a

Finit e St r ike Range.............................................................. 32

VI. FROM VARIANCE TO VOLATILITY CONTRACTS ................................. 33

Dynamic Replicat ion of a Volat ilit y Swap ............................... 34

CONCLUSIONS AND FUTURE INNOVATIONS ............................................ 36

APPENDIX A: REPLICATING LOGARITHMIC PAYOFFS .............................. 37

APPENDIX B: SKEW LINEAR IN STRIKE .................................................. 40

APPENDIX C: SKEW LINEAR IN DELTA ................................................... 44

APPENDIX D: STATIC AND DYNAMIC REPLICATION OF A

VOLATILITY SWAP .................................................. 48

REFERENCES .......................................................................................... 50

1

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

INTRO DUC TIO N A st ock’s volat ilit y is t he simplest measur e of it s r iskiness or uncer -

t aint y. For mally, t he volat ilit y σ

R

is t he annualized st andar d deviat ion

of t he st ock’s r et ur ns dur ing t he per iod of int er est , wher e t he subscr ipt

R denot es t he obser ved or “r ealized” volat ilit y. This not e is concer ned

wit h volat ilit y swaps and ot her inst r ument s suit able for t r ading vola-

t ilit y

1

.

Why t r ade volat ilit y? J ust as st ock invest or s t hink t hey know some-

t hing about t he dir ect ion of t he st ock mar ket , or bond invest or s t hink

t hey can for esee t he pr obable dir ect ion of int er est r at es, so you may

t hink you have insight int o t he level of fut ur e volat ilit y. If you t hink

cur r ent volat ilit y is low, for t he r ight pr ice you might want t o t ake a

posit ion t hat pr oﬁt s if volat ilit y incr eases.

Invest or s who want t o obt ain pur e exposur e t o t he dir ect ion of a st ock

pr ice can buy or sell shor t t he st ock. What do you do if you simply want

exposur e t o a st ock’s volat ilit y?

St ock opt ions ar e impur e: t hey pr ovide exposur e t o bot h t he dir ect ion

of t he st ock pr ice and it s volat ilit y. If you hedge t he opt ions accor ding

t o Black-Scholes pr escr ipt ion, you can r emove t he exposur e t o t he st ock

pr ice. But delt a-hedging is at best inaccur at e because t he r eal wor ld

violat es many of t he Black-Scholes assumpt ions: volat ilit y cannot be

accur at ely est imat ed, st ocks cannot be t r aded cont inuously, t r ansac-

t ions cost s cannot be ignor ed, mar ket s somet imes move discont inu-

ously and liquidit y is oft en a pr oblem. Never t heless, imper fect as t hey

ar e, unt il r ecent ly opt ions wer e t he only volat ilit y vehicle available.

Vola tility Swa p s The easy way t o t r ade volat ilit y is t o use volatility swaps, somet imes

called realized volatility forward contracts, because t hey pr ovide pur e

exposur e t o volat ilit y (and only t o volat ilit y).

A st ock volat ilit y swap is a for war d cont r act on annualized volat ilit y.

It s payoff at expir at ion is equal t o

( EQ 1)

wher e σ

R

is t he r ealized st ock volat ilit y (quot ed in annual t er ms) over

t he life of t he cont r act , K

vol

is t he annualized volat ilit y deliver y pr ice,

and N is t he not ional amount of t he swap in dollar s per annualized vol-

at ilit y point . The holder of a volat ilit y swap at expir at ion r eceives N

dollar s for ever y point by which t he st ock’s r ealized volat ilit y σ

R

has

1. For a discussion of volat ilit y as an asset class, see Der man, Kamal,

Kani, McClur e, Pir ast eh, and Zou (1996).

σ

R

K

v ol

– ( ) N ×

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

2

exceeded t he volat ilit y deliver y pr ice K

vol

. He or she is swapping a ﬁxed

volat ilit y K

vol

for t he act ual (“ﬂoat ing”) fut ur e volat ilit y σ

R.

The deliver y pr ice K

vol

is t ypically quot ed as a volat ilit y, for example

30%. The not ional amount is t ypically quot ed in dollar s per volat ilit y

point , for example, N = $250,000/(volat ilit y point ). As wit h all for war d

cont r act s or swaps, t he fair value of volat ilit y at any t ime is t he deliv-

er y pr ice t hat makes t he swap cur r ent ly have zer o value.

The pr ocedur e for calculat ing t he r ealized volat ilit y should be clear ly

speciﬁed wit h r espect t o t he following aspect s:

• The sour ce and obser vat ion fr equency of st ock or index pr ices – for

example, using daily closing pr ices of t he S&P 500 index;

• The annualizat ion fact or in moving fr om daily or hour ly obser va-

t ions t o annualized volat ilit ies – for example, using 260 business

days per year as a mult iplicat ive fact or in comput ing annualized

var iances fr om daily r et ur ns; and

• Whet her t he st andar d deviat ion of r et ur ns is calculat ed by subt r act -

ing t he sample mean fr om each r et ur n, or by assuming a zer o mean.

The zer o mean met hod is t heor et ically pr efer able, because it cor r e-

sponds most closely t o t he cont r act t hat can be r eplicat ed by opt ions

por t folios. For fr equent ly obser ved pr ices, t he differ ence is usually

negligible.

Who C a n Use Vola tility

Swa p s?

Volat ilit y has sever al char act er ist ics t hat make t r ading at t r act ive. It is

likely t o gr ow when uncer t aint y and r isk incr ease. As wit h int er est

r at es, volat ilit ies appear t o r ever t t o t he mean; high volat ilit ies will

event ually decr ease, low ones will likely r ise. Finally, volat ilit y is oft en

negat ively cor r elat ed wit h st ock or index level, and t ends t o st ay high

aft er lar ge downwar d moves in t he mar ket . Given t hese t endencies,

sever al uses for volat ilit y swaps follow.

Di recti onal Tradi ng of Volati li ty Levels. Client s who want t o spec-

ulat e on t he fut ur e levels of st ock or index volat ilit y can go long or

shor t r ealized volat ilit y wit h a swap. This pr ovides a much mor e dir ect

met hod t han t r ading and hedging opt ions. For example, if you for esee a

r apid decline in polit ical and ﬁnancial t ur moil aft er a for t hcoming elec-

t ion, a shor t posit ion in volat ilit y might be appr opr iat e.

Tradi ng the Spread between Reali zed and Impli ed Volati li ty

Levels. As we will show lat er, t he fair deliver y pr ice K

vol

of a volat ilit y

swap is a value close t o t he level of cur r ent implied volat ilit ies for

opt ions wit h t he same expir at ion as t he swap. Ther efor e, by unwinding

3

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

t he swap befor e expir at ion, you can t r ade t he spr ead bet ween r ealized

and implied volat ilit y.

Hedgi ng Impli ci t Volati li ty Exposure. Ther e ar e sever al busi-

nesses t hat ar e implicit ly shor t volat ilit y:

• Risk ar bit r ageur s or hedge funds oft en t ake posit ions which assume

t hat t he spr ead bet ween st ocks of companies planning mer ger s will

nar r ow. If over all mar ket volat ilit y incr eases, t he mer ger may

become less likely and t he spr ead may widen.

• Invest or s following act ive benchmar king st r at egies may r equir e

mor e fr equent r ebalancing and gr eat er t r ansact ions expenses dur -

ing volat ile per iods.

• Por t folio manager s who ar e judged against a benchmar k have t r ack-

ing er r or t hat may incr ease in per iods of higher volat ilit y.

• Equit y funds ar e pr obably shor t volat ilit y because of t he negat ive

cor r elat ion bet ween index level and volat ilit y. As global equit y cor r e-

lat ions have incr eased, diver siﬁcat ion acr oss count r ies has become a

less effect ive por t folio hedge. Since volat ilit y is one of t he few

par amet er s t hat t ends t o incr ease dur ing global equit y declines, a

long volat ilit y hedge may be appr opr iat e, especially for ﬁnancial

businesses.

Va ria nc e Swa p s Alt hough opt ions mar ket par t icipant s t alk of volat ilit y, it is variance,

or volat ilit y squar ed, t hat has mor e fundament al t heor et ical signiﬁ-

cance. This is so because t he cor r ect way t o value a swap is t o value t he

por t folio t hat r eplicat es it , and t he swap t hat can be r eplicat ed most

r eliably (by por t folios of opt ions of var ying st r ikes, as we show lat er ) is

a variance swap.

A var iance swap is a for war d cont r act on annualized var iance, t he

squar e of t he r ealized volat ilit y. It s payoff at expir at ion is equal t o

( EQ 2)

wher e is t he r ealized st ock var iance (quot ed in annual t er ms) over

t he life of t he cont r act , K

var

is t he deliver y pr ice for var iance, and N is

t he not ional amount of t he swap in dollar s per annualized volat ilit y

point squar ed. The holder of a var iance swap at expir at ion r eceives N

dollar s for ever y point by which t he st ock’s r ealized var iance has

exceeded t he var iance deliver y pr ice K

var

.

σ

R

2

K

v ar

– ( ) N ×

σ

R

2

σ

R

2

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

4

Though t heor et ically simpler, var iance swaps ar e less commonly

t r aded, and so t heir quot ing convent ions var y. The deliver y pr ice K

var

can be quot ed as a volat ilit y squar ed, for example (30%)

2

. Similar ly, for

example, t he not ional amount can be expr essed as $100,000/(one vola-

t ilit y point )

2

. The fair value of var iance is t he deliver y pr ice t hat makes

t he swap have zer o value.

O utline Most of t his not e will focus on t he t heor y and pr oper t ies of var iance

swaps, which pr ovide similar volat ilit y exposur e t o st r aight volat ilit y

swaps. Because of it s fundament al r ole, var iance can ser ve as t he basic

building block for const r uct ing ot her volat ilit y-dependent inst r ument s.

At t he end, we will r et ur n t o a discussion of t he addit ional r isks

involved in r eplicat ing and valuing volat ilit y swaps.

Sect ion I pr esent s an int uit ive, Black-Scholes-based account of t he fun-

dament al st r at egy by which a var iance swap can be r eplicat ed and val-

ued. Fir st , we show t hat t he hedging of a (slight ly) exot ic st ock opt ion,

t he log contract, pr ovides a payoff equal t o t he var iance of t he st ock’s

r et ur ns under a fair ly wide set of cir cumst ances. Then, we explain how

t his exot ic opt ion it self can be r eplicat ed by a por t folio of st andar d

st ock opt ions wit h a r ange of st r ikes, so t hat t heir mar ket pr ices det er -

mine t he cost of t he var iance swap. We also pr ovide insight int o t he

swap by showing, fr om a var iet y of viewpoint s, how t he appar ent ly

complex hedged log cont r act pr oduces an inst r ument wit h t he simple

const ant exposur e t o t he r ealized var iance of a var iance swap.

Sect ion II der ives t he same r esult s much mor e r igor ously and gener -

ally, wit hout depending on t he full validit y of t he Black-Scholes model.

Though mor e difﬁcult , t his pr esent at ion is capable of much gr eat er

gener alizat ion.

In Sect ion III, we pr ovide a det ailed numer ical example of t he valua-

t ion of a var iance swap. Some pr act ical issues concer ning t he choice of

st r ikes ar e also discussed.

The fair value of t he var iance swap is det er mined by t he cost of t he

r eplicat ing por t folio of opt ions. This cost , especially for index opt ions, is

signiﬁcant ly affect ed by t he volat ilit y smile or skew. Ther efor e, we

devot e Sect ion IV t o t he effect s of t he skew. In par t icular, for a skew

linear in st r ike or linear in delt a, we der ive t heor et ical for mulas t hat

allow us t o simply det er mine t he appr oximat e effect of t he skew on t he

fair value of index var iance swaps, wit hout det ailed numer ical compu-

t at ion. The for mulas and t he int uit ion t hey pr ovide ar e beneﬁcial in

r apidly est imat ing t he effect of changes in t he skew on swap values.

5

QUANTITATIVE STRATEGIES RESEARCH NOTES

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Goldman

The fair value of a var iance swap is based on (1) t he abilit y t o r eplicat e

a log cont r act by means of a por t folio of opt ions wit h a (cont inuous)

r ange of st r ikes, and (2) on classical opt ions valuat ion t heor y, which

assumes cont inuous st ock pr ice evolut ion. In pr act ice, not all st r ikes

ar e available, and st ock pr ices can jump. Sect ion V discusses t he effect s

of t hese r eal limit at ions on pr icing.

Finally, Sect ion VI explains t he r isks involved in r eplicat ing a volat ilit y

cont r act . Since var iance can be r eplicat ed r elat ively simply, it is useful

t o r egar d volat ilit y as t he squar e r oot of var iance. Fr om t his point of

view, volat ilit y is it self a squar e-r oot der ivat ive cont r act on var iance.

Thus, a volat ilit y swap can be dynamically hedged by t r ading t he

under lying var iance swap, and it s value depends on t he volat ilit y of t he

under lying var iance – t hat is, on t he volat ilit y of volat ilit y.

Four appendices cover some mor e advanced mat hemat ics. In Appendix

A, we der ive t he det ails of t he r eplicat ion of a log cont r act by means of

a cont inuum of opt ion st r ikes. It also shows how t he r eplicat ion can be

appr oximat ed in pr act ice when only a discr et e set of st r ikes ar e avail-

able. In Appendix B, we der ive t he appr oximat e for mulas for t he value

of an index var iance cont r act in t he pr esence of a volat ilit y skew t hat

var ies linear ly wit h st r ike. In Appendix C, we der ive t he analogous for -

mulas for a skew var ying linear ly wit h t he delt a exposur e of t he

opt ions. Appendix D pr ovides addit ional insight int o t he st at ic and

dynamic hedging of a volat ilit y swap using t he var iance as an under -

lyer.

QUANTITATIVE STRATEGIES RESEARCH NOTES

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Goldman

6

REPLICATING

VARIANC E SWAPS:

FIRST STEPS

In t his sect ion, we explain t he r eplicat ing st r at egy t hat capt ur es r eal-

ized var iance. The cost of implement ing t hat st r at egy is t he fair value

of fut ur e r ealized var iance.

The Intuitive

Ap p roa c h: C re a ting a

Portfolio of O p tions

Whose Va ria nc e Se n-

sitivity is Ind e p e nd e nt

of Stoc k Pric e

We appr oach var iance r eplicat ion by building on t he r eader ’s assumed

familiar it y wit h t he st andar d Black-Scholes model. In t he next sect ion,

we shall pr ovide a mor e gener al pr oof t hat you can r eplicat e var iance,

even when some of t he Black-Scholes assumpt ions fail, as long as t he

st ock pr ice evolves cont inuously – t hat is, wit hout jumps.

We ease t he development of int uit ion by assuming her e t hat t he r isk-

less int er est r at e is zer o. Suppose at t ime t you own a st andar d call

opt ion of st r ike K and expir at ion T, whose value is given by t he Black-

Scholes for mula , wher e S is t he cur r ent st ock pr ice, τ

is t he t ime t o expir at ion (T − t), is t he r et ur n volat ilit y of t he st ock,

is t he st ock’s var iance, and is t he t ot al var iance of t he

st ock t o expir at ion. (We have wr it t en t he opt ion value as a funct ion of

in or der t o make clear t hat all it s dependence on bot h volat ilit y

and t ime t o expir at ion is expr essed in t he combined var iable .)

We will call t he exposur e of an opt ion t o a st ock’s var iance V ; it mea-

sur es t he change in value of t he posit ion r esult ing fr om a change in

var iance

2

. Figur e 1a shows a gr aph of how V var ies wit h st ock pr ice S,

for each of t hr ee differ ent opt ions wit h st r ikes 80, 100 and 120. For

each st r ike, t he var iance exposur e V is lar gest when t he opt ion is at

t he money, and falls off r apidly as t he st ock pr ice moves in or out of t he

money. V is closely r elat ed t o t he t ime sensit ivit y or t ime decay of t he

opt ion, because, in t he Black-Scholes for mula wit h zer o int er est r at e,

opt ions values depend on t he t ot al var iance .

If you want a long posit ion in fut ur e r ealized var iance, a single opt ion

is an imper fect vehicle: as soon as t he st ock pr ice moves, your sensit iv-

it y t o fur t her changes in var iance is alt er ed. What you want is a por t fo-

2. Her e, we deﬁne t he sensit ivit y , wher e

. We will somet imes r efer t o V as “var iance

vega”. Not e t hat d

1

depends only on t he t wo combinat ions S / K and

. V decr eases ext r emely r apidly as S leaves t he vicinit y of t he

st r ike K.

C

BS

S K σ τ , , ( )

σ

σ

2

v σ

2

τ =

σ τ

σ τ

V

σ

2

∂

∂C

B S S τ

2σ

-----------

d

1

2

2 ⁄ – ( ) exp

2π

-------------------------------- = =

d

1

S K ⁄ ( ) log σ

2

τ ( ) 2 ⁄ +

σ τ

------------------------------------------------------ =

σ τ

σ

2

τ

7

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

lio whose sensit ivit y t o r ealized var iance is independent of t he st ock

pr ice S.

To obt ain a por t folio t hat r esponds t o volat ilit y or var iance indepen-

dent of moves in t he st ock pr ice, you need t o combine opt ions of many

st r ikes. What combinat ion of st r ikes will give you such undilut ed var i-

ance exposur e?

Figur e 1b shows t he var iance exposur e for t he por t folio consist ing of all

t hr ee opt ion st r ikes in Figur e 1a. The dot t ed line r epr esent s t he sum of

equally weight ed st r ikes; t he solid line r epr esent s t he sum wit h

weight s in inver se pr opor t ion t o t he squar e of t heir st r ike. Figur es 1c, e

and g show t he individual sensit ivit ies t o var iance of incr easing num-

ber s of opt ions, each panel having t he opt ions mor e closely spaced. Fig-

ur es 1d, f and h show t he sensit ivit y for t he equally-weight ed and

st r ike-weight ed por t folios. Clear ly, t he por t folio wit h weight s inver sely

pr opor t ional t o pr oduces a V t hat is vir t ually independent of st ock

pr ice S, as long as S lies inside t he r ange of available st r ikes and far

fr om t he edge of t he r ange, and pr ovided t he st r ikes ar e dist r ibut ed

evenly and closely.

Appendix A pr ovides a mat hemat ical der ivat ion of t he r equir ement

t hat opt ions be weight ed inver sely pr opor t ional t o in or der t o

achieve const ant V . You can also under st and t his int uit ively. As t he

st ock pr ice moves up t o higher values, each addit ional opt ion of higher

st r ike in t he por t folio will pr ovide an addit ional cont r ibut ion t o V pr o-

por t ional t o t hat st r ike. This follows fr om t he for mula in foot not e 2,

and you can obser ve it in t he incr easing height of t he V -peaks in Fig-

ur e 1a. An opt ion wit h higher st r ike will t her efor e pr oduce a V cont r i-

but ion t hat incr eases wit h S. In addit ion, t he cont r ibut ions of all

opt ions over lap at any deﬁnit e S. Ther efor e, t o offset t his accumulat ion

of S -dependence, one needs diminishing amount s of higher-st r ike

opt ions, wit h weight s inver sely pr opor t ional t o .

If you own a por t folio of opt ions of all st r ikes, weight ed in inver se pr o-

por t ion t o t he squar e of t he st r ike level, you will obt ain an exposur e t o

var iance t hat is independent of st ock pr ice, just what is needed t o t r ade

var iance. What does t his por t folio of opt ions look like, and how does

t r ading it capt ur e var iance?

Consider t he por t folio of opt ions of all st r ikes K and a single

expir at ion τ, weight ed inver sely pr opor t ional t o . Because out -of-

K

2

K

2

K

2

Π S σ τ , ( )

K

2

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

8

20 60 100 140 180 20 60 100 140 180

20 60 100 140 180 20 60 100 140 180

20 60 100 140 180 20 60 100 140 180

20 60 100 140 180 20 60 100 140 180

strikes: 80,100,120

equally

weighted

strikes 60 to 140

strikes 20 to 180

spaced 1 apart

FIG URE 1. The va ria nc e e xp osure , V , of p ortfolios of c a ll op tions of d iffe re nt

strike s a s a func tion of stoc k p ric e S. Ea c h ﬁg ure on the le ft shows the

ind ivid ua l V

i

c ontrib utions for e a c h op tion of strike K

i

. The c orre sp ond ing

ﬁg ure on the rig ht shows the sum of the c ontrib utions, we ig hte d two

d iffe re nt wa ys; the d otte d line c orre sp ond s to a n e q ua lly- we ig hte d sum of

op tions; the solid line c orre sp ond s to we ig hts inve rse ly p rop ortiona l to K

2

,

a nd b e c ome s tota lly ind e p e nd e nt of stoc k p ric e S insid e the strike ra ng e

spaced 20 apart

strikes 60 to 140

spaced 10 apart

(a)

(c)

(e)

(g)

(b)

(d)

(f)

(h)

weighted

inversely

proportional

to square

of strike

9

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

t he-money opt ions ar e gener ally mor e liquid, we employ put opt ions

for st r ikes K var ying cont inuously fr om zer o up t o some

r efer ence pr ice S

*,

and call opt ions for st r ikes var ying

cont inuously fr om S

*

t o inﬁnit y

3

. You can t hink of S

*

as t he appr oxi-

mat e at -t he-money for war d st ock level t hat mar ks t he boundar y

bet ween liquid put s and liquid calls.

At expir at ion, when t · T, one can show t hat t he sum of all t he payoff

values of t he opt ions in t he por t folio is simply

( EQ 3)

wher e log( ) denot es t he nat ur al logar it hm funct ion, and S

T

is t he t er -

minal st ock pr ice.

Similar ly, at t ime t you can sum all t he Black-Scholes opt ions values t o

show t hat t he t ot al por t folio value is

( EQ 4)

wher e S is t he st ock pr ice at t ime t. Not e how lit t le t he value of t he

por t folio befor e expir at ion differ s fr om it s value at expir at ion at t he

same st ock pr ice. The only differ ence is t he addit ional value due t o half

t he t ot al var iance .

Clear ly, t he var iance exposur e of Π is

( EQ 5)

To obt ain an init ial exposur e of $1 per volat ilit y point squar ed, you

need t o hold (2/T) unit s of t he por t folio Π. Fr om now on, we will use Π t o

r efer t o t he value of t his new por t folio, namely

3. For mally, t he expr ession for t he por t folio is given by

P S K σ τ , , ( )

C S K σ τ , , ( )

Π S σ τ , ( )

1

K

2

-------C S K σ τ , , ( )

K S

*

>

∑

1

K

2

------- P S K σ τ , , ( )

K S

*

<

∑

+ =

Π S

T

0 , ( )

S

T

S

*

–

S

*

--------------------

S

T

S

*

-------

¸ ,

¸ _

log – =

Π S σ τ , ( )

S S

*

–

S

*

----------------

S

S

*

------

¸ ,

¸ _

log –

σ

2

τ

2

--------- + =

σ

2

τ

V

τ

2

--- =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

10

( EQ 6)

The ﬁr st t er m in t he payoff in Equat ion 6, (S − S

*

)/S

*

, descr ibes 1/S

*

for war d cont r act s on t he st ock wit h deliver y pr ice S

*

. It is not r eally an

opt ion; it s value r epr esent s a long posit ion in t he st ock (value S ) and a

shor t posit ion in a bond (value S

*

), which can be st at ically r eplicat ed,

once and for all, wit hout any knowledge of t he st ock’s volat ilit y. The

second t er m, , descr ibes a shor t posit ion in a log contract

4

wit h r efer ence value S

*

, a so-called exot ic opt ion whose payoff is pr o-

por t ional t o t he log of t he st ock at expir at ion, and whose cor r ect hedg-

ing depends on t he volat ilit y of t he st ock. All of t he volat ilit y sensit ivit y

of t he weight ed por t folio of opt ions we have cr eat ed is cont ained in t he

log cont r act .

Figur e 2 gr aphically illust r at es t he equivalence bet ween (1) t he

summed, weight ed payoffs of put s and calls and (2) a long posit ion in a

for war d cont r act and a shor t posit ion in a log cont r act .

4. The log cont r act was ﬁr st discussed in Neuber ger (1994). See also Neu-

ber ger (1996).

Π S σ τ , ( )

2

T

----

S S

*

–

S

*

----------------

S

S

*

------

¸ ,

¸ _

log –

τ

T

----σ

2

+ =

S S

*

⁄ ( ) log –

20 60 100 140 180 20 60 100 140 180

FIG URE 2. An e xa mp le tha t illustra te s the e q uiva le nc e a t e xp ira tion

b e twe e n ( 1) Π( S

T

,0) the we ig hte d sum of p uts a nd c a lls, with we ig ht

inve rse ly p rop ortiona l to the sq ua re of the strike , a nd ( 2) the p a yoff of a

long p osition in a forwa rd c ontra c t a nd a short p osition in a log c ontra c t.

( a ) Ind ivid ua l c ontrib utions to the p a yoff from p ut op tions with a ll inte g e r

strike s from 20 to 99, a nd c a ll op tions with a ll inte g e r strike s from 100 to 180.

( b ) The p a yoff of 1/ 100 of a long p osition in a forwa rd c ontra c t with

d e live ry p ric e 100 a nd one short p osition in a log c ontra c t with re fe re nc e

va lue 100.

S

T

S

*

–

S

*

--------------------

S

T

S

*

------- log –

Π S

T

0 , ( )

( a ) ( b )

11

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

Tra d ing Re a lize d

Vola tility with a Log

C ontra c t

For now, assume t hat we ar e in a Black-Scholes wor ld wher e t he

implied volat ilit y is t he est imat e of fut ur e r ealized volat ilit y. If you

t ake a posit ion in t he por t folio Π, t he fair value you should pay at t ime

when t he st ock pr ice is S

0

is

At expir at ion, if t he r ealized volat ilit y t ur ns out t o have been , t he

init ial fair value of t he posit ion capt ur ed by delt a-hedging would have

been

The net payoff on t he posit ion, hedged t o expir at ion, will be

( EQ 7)

Looking back at Equat ion 2, you will see t hat by rehedging the position

in log contracts, you have, in effect, been the owner of a position in a

variance swap with fair strike K

var

= and face value $1. You will

have pr oﬁt ed (or lost ) if r ealized volat ilit y has exceeded (or been

exceeded by) implied volat ilit y.

The Ve g a , G a mma

a nd The ta of a Log

C ontra c t

In Equat ion 6 we showed t hat , in a Black-Scholes wor ld wit h zer o

int er est r at es and zer o dividend yield, t he por t folio of opt ions whose

var iance vega is independent of t he st ock pr ice S can be wr it t en

The t er m r epr esent s a long posit ion in t he st ock and a shor t

posit ion in a bond, bot h of which can be st at ically hedged wit h no

dependence on volat ilit y. In cont r ast , t he log( ) t er m needs cont inual

dynamic r ehedging. Ther efor e, let us concent r at e on t he log cont r act

t er m alone, whose value at t ime t for a logar it hmic payoff at t ime T is

( EQ 8)

σ

I

t 0 =

Π

0

2

T

----

S

0

S

*

–

S

*

-------------------

S

0

S

*

-------

¸ ,

¸ _

log – σ

I

2

+ =

σ

R

Π

0

2

T

----

S

0

S

*

–

S

*

-------------------

S

0

S

*

-------

¸ ,

¸ _

log – σ

R

2

+ =

payoff σ

R

2

σ

I

2

– ( ) =

σ

I

2

Π S σ t T , , , ( )

2

T

----

S S

*

–

S

*

----------------

S

S

*

------

¸ ,

¸ _

log –

T t – ( )

T

-----------------σ

2

+ =

S S

*

– ( )

L S σ t T , , , ( )

2

T

----

S

S

*

------

¸ ,

¸ _

log –

T t – ( )

T

-----------------σ

2

+ =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

12

The sensit ivit ies of t he value of t his por t folio ar e pr ecisely appr opr iat e

for t r ading var iance, as we now show.

The var iance vega of t he por t folio in Equat ion 8 is

( EQ 9)

The exposur e t o var iance is equal t o 1 at t = 0, and decr eases linear ly t o

zer o as t he cont r act appr oaches expir at ion.

The t ime decay of t he log cont r act , t he r at e at which it s value changes

if t he st ock pr ice r emains unchanged as t ime passes, is

( EQ 10)

The cont r act loses t ime value at a const ant r at e pr opor t ional t o it s var i-

ance, so t hat at expir at ion, all t he init ial var iance has been lost .

The log cont r act ’s exposur e t o st ock pr ice is

shar es of st ock. That is, since each shar e of st ock is wor t h S, you need a

const ant long posit ion in $(2/T) wor t h of st ock t o be hedged at any t ime.

The gamma of t he por t folio, t he r at e at which t he exposur e changes as

t he st ock pr ice moves, is

( EQ 11)

Gamma is a measur e of t he r isk of hedging an opt ion. The log con-

t r act ’s gamma, being t he sum of t he gammas of a por t folio of put s and

calls, is a smoot her funct ion of S t han t he shar ply peaked gamma of a

single opt ion.

Equat ions 10 and 11 can be combined t o show t hat

( EQ 12)

Equat ion 12 is t he essence of t he Black-Scholes opt ions pr icing t heor y.

It st at es t hat t he disadvant age of negat ive t het a (t he decr ease in value

wit h t ime t o expir at ion) is offset by t he beneﬁt of posit ive gamma (t he

cur vat ur e of t he payoff).

V

T t –

T

------------

¸ ,

¸ _

=

θ

1

T

----σ

2

– =

∆

2

T

----

1

S

---- – =

Γ

2

T

----

1

S

2

------- =

θ

1

2

---ΓS

2

σ

2

+ 0 =

13

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

Imp e rfe c t He d g e s It t akes an inﬁnit e number of st r ikes, appr opr iat ely weight ed, t o r epli-

cat e a var iance swap. In pr act ice, t his isn’t possible, even when t he

st ock and opt ions mar ket sat isfy all t he Black-Scholes assumpt ions:

t her e ar e only a ﬁnit e number of opt ions available at any mat ur it y. Fig-

ur e 1 illust r at es t hat a ﬁnit e number of st r ikes fails t o pr oduce a uni-

for m V as t he st ock pr ice moves out side t he r ange of t he available

st r ikes. As long as t he st ock pr ice r emains wit hin t he st r ike r ange,

t r ading t he imper fect ly r eplicat ed log cont r act will allow var iance t o

accr ue at t he cor r ect r at e. Whenever t he st ock pr ice moves out side, t he

r educed vega of t he imper fect ly r eplicat ed log cont r act will make it less

r esponsive t han a t r ue var iance swap.

Figur e 3 shows how t he var iance vega of a t hr ee-mont h var iance swap

is affect ed by imper fect r eplicat ion. Figur e 3a shows t he ideal var iance

vega t hat r esult s fr om a por t folio of put s and calls of all st r ikes fr om

zer o t o inﬁnit y, weight ed in inver se pr opor t ion t o t he st r ike squar ed.

Her e t he var iance vega is independent of st ock pr ice level, and

decr eases linear ly wit h t ime t o expir at ion, as expect ed for a swap

whose value is pr opor t ional t o t he r emaining var iance at any t ime.

Figur e 3b shows st r ikes fr om $75 t o $125, unifor mly spaced $1 apar t .

Her e, deviat ion fr om const ant var iance vega develops at t he t ail of t he

st r ike r ange, and t he deviat ion is gr eat er at ear lier t imes. Finally, Fig-

ur e 3c shows t he vega for st r ikes fr om $20 t o $200, spaced $10 apar t .

Now, alt hough t he r ange of st r ikes is gr eat er, t he coar ser spacing

causes t he vega sur face t o develop cor r ugat ions bet ween st r ike values

t hat gr ow mor e pr onounced closer t o expir at ion.

The Limita tions of the

Intuitive Ap p roa c h

A var iance swap has a payoff pr opor t ional t o r ealized var iance. In t his

sect ion, assuming t he Black-Scholes wor ld for st ock and opt ions mar -

ket s, we have shown t hat t he dynamic, cont inuous hedging of a log con-

t r act pr oduces a payoff whose value is pr opor t ional t o fut ur e r ealized

var iance. We have also shown t hat you can use a por t folio of appr opr i-

at ely weight ed put s and calls t o appr oximat e a log cont r act .

The somewhat int uit ive der ivat ions in t his sect ion have assumed t hat

int er est r at es and dividend yields ar e zer o, but it is not har d t o gener -

alize t hem. We have also assumed t hat all t he Black-Scholes assump-

t ions hold. In pr act ice, in t he pr esence of an implied volat ilit y skew, it

is difﬁcult t o ext end t hese ar gument clear ly. Ther efor e, we move on t o a

mor e gener al and r igor ous der ivat ion of t he value of var iance swaps

based on r eplicat ion. Many of t he r esult s will be similar, but t he condi-

t ions under which t hey hold, and t he cor r ect answer s when t hey do not

hold, will be mor e easily under st andable.

σ

2

τ

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

14

FIG URE 3. The va ria nc e ve g a , V , of a p ortfolio of p uts a nd c a lls, we ig hte d

inve rse ly p rop ortiona l to the sq ua re of the strike le ve l, a nd c hose n to

re p lic a te a thre e - month va ria nc e swa p . ( a ) An inﬁnite numb e r of strike s.

( b ) Strike s from $75 to $125, uniformly sp a c e d $1 a p a rt. ( c ) Strike s from $20

to $200, uniformly sp a c e d $10 a p a rt.

v

60

80

100

120

140

S

0

0.1

0.2

τ

v

60

80

100

120

140

S

0

0.1

0.2

τ

v

60

80

100

120

140

S

0

0.1

0.2

τ

V

V

V

( a )

( b )

( c )

15

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

REPLICATING

VARIANC E SWAPS:

G ENERAL RESULTS

In t he pr evious sect ion, we explained how t o r eplicat e a var iance swap

by means of a por t folio of opt ions whose payoffs appr oximat e a log con-

t r act . Alt hough our explanat ion depended on t he validit y of t he Black-

Scholes model, t he r esult – t hat t he dynamic hedging of a log cont r act

capt ur es r ealized volat ilit y – holds t r ue mor e gener ally. The only

assumpt ion we will make about t he fut ur e under lyer evolut ion is t hat

it is diffusive, or cont inuous – t his means t hat no jumps ar e allowed.

(In a lat er sect ion, we will consider t he effect s of discont inuous st ock

pr ice movement s on t he success of t he r eplicat ion.) Ther efor e, we

assume t hat t he st ock pr ice evolut ion is given by

( EQ 13)

Her e, we assume t hat t he dr ift µ and t he cont inuously-sampled volat il-

it y σ ar e ar bit r ar y funct ions of t ime and ot her par amet er s. These

assumpt ions include, but ar e not r est r ict ed t o, implied t r ee models in

which t he volat ilit y is a funct ion of st ock pr ice and t ime only.

For simplicit y of pr esent at ion, we assume t he st ock pays no dividends;

allowing for dividends does not signiﬁcant ly alt er t he der ivat ion.

The t heor et ical deﬁnit ion of r ealized var iance for a given pr ice hist or y

is t he cont inuous int egr al

( EQ 14)

This is a good appr oximat ion t o t he var iance of daily r et ur ns used in

t he cont r act t er ms of most var iance swaps.

Concept ually, valuing a var iance for war d cont r act or “swap” is no dif-

fer ent t han valuing any ot her der ivat ive secur it y. The value of a for -

war d cont r act F on fut ur e r ealized var iance wit h st r ike K is t he

expect ed pr esent value of t he fut ur e payoff in t he r isk-neut r al wor ld:

( EQ 15)

Her e r is t he r isk-fr ee discount r at e cor r esponding t o t he expir at ion

dat e T, and E[ ] denot es t he expect at ion.

The fair deliver y value of fut ur e r ealized var iance is t he st r ike

for which t he cont r act has zer o pr esent value:

( EQ 16)

d S

t

S

t

---------- µ t ... , ( )d t σ t ... , ( )d Z

t

+ =

σ S t , ( )

V

1

T

---- σ

2

t … , ( ) t d

0

T

∫

=

F E e

rT –

V K – ( ) [ ] =

K

v ar

K

v ar

E V [ ] =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

16

If t he fut ur e volat ilit y in Equat ion 13 is speciﬁed, t hen one appr oach

for calculat ing t he fair pr ice of var iance is t o dir ect ly calculat e t he r isk-

neut r al expect at ion

( EQ 17)

No one knows wit h cer t aint y t he value of fut ur e volat ilit y. In implied

t r ee models

5

, t he so-called local volat ilit y consist ent wit h all

cur r ent opt ions pr ices is ext r act ed fr om t he mar ket pr ices of t r aded

st ock opt ions. You can t hen use simulat ion t o calculat e t he fair var i-

ance K

var

as t he aver age of t he exper ienced var iance along each simu-

lat ed pat h consist ent wit h t he r isk-neut r al st ock pr ice evolut ion given

of Equat ion 13, wher e t he dr ift µ is set equal t o t he r iskless r at e.

The above appr oach is good for valuing t he cont r act , but it does not

pr ovide insight int o how t o r eplicat e it . The essence of t he r eplicat ion

st r at egy is t o devise a posit ion t hat , over t he next inst ant of t ime, gen-

er at es a payoff pr opor t ional t o t he incr ement al var iance of t he st ock

dur ing t hat t ime

6

.

By applying It o’s lemma t o , we ﬁnd

( EQ 18)

Subt r act ing Equat ion 18 fr om Equat ion 13, we obt ain

( EQ 19)

in which all dependence on t he dr ift has cancelled. Summing Equa-

t ion 19 over all t imes fr om 0 t o T, we obt ain t he cont inuously-sampled

var iance

5. See, for example, Der man and Kani (1994), Dupir e (1994) and Der man,

Kani and Zou (1996).

6. This appr oach was ﬁr st out lined in Der man, Kamal, Kani, and Zou

(1996). For an alt er nat ive discussion, see Car r and Madan (1998).

K

v ar

1

T

---- E σ

2

t … , ( ) t d

0

T

∫

=

σ S t , ( )

S

t

log

d S

t

log ( ) µ

1

2

---σ

2

–

¸ ,

¸ _

d t σd Z

t

+ =

d S

t

S

t

---------- d S

t

log ( ) –

1

2

---σ

2

d t =

µ

17

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

( EQ 20)

This mat hemat ical ident it y dict at es t he r eplicat ion st r at egy for var i-

ance. The ﬁr st t er m in t he br acket s can be t hought of as t he net out -

come of cont inuous r ebalancing a st ock posit ion so t hat it is always

inst ant aneously long shar es of st ock wor t h $1. The second t er m

r epr esent s a static shor t posit ion in a cont r act which, at expir at ion,

pays t he logar it hm of t he t ot al r et ur n. Following t his cont inuous r ebal-

ancing st r at egy capt ur es t he r ealized var iance of t he st ock fr om incep-

t ion t o expir at ion at t ime T. Not e t hat no expect at ions or aver ages have

been t aken – Equat ion 20 guar ant ees t hat var iance can be capt ur ed no

mat t er which pat h t he st ock pr ice t akes, as long as it moves cont inu-

ously.

Va luing a nd Pric ing

the Va ria nc e Swa p

Equat ion 20 pr ovides anot her met hod for calculat ing t he fair var iance.

Inst ead of aver aging over fut ur e var iances, as in Equat ion 17, one can

t ake t he expect ed r isk-neut r al value of t he r ight -hand side of Equat ion

20 t o obt ain t he cost of r eplicat ion dir ect ly, so t hat

( EQ 21)

The expect ed value of t he ﬁr st t er m in Equat ion 21 account s for t he

cost of r ebalancing. In a r isk-neut r al wor ld wit h a const ant r isk-fr ee

r at e r, t he under lyer evolves accor ding t o:

( EQ 22)

so t hat t he r isk-neut r al pr ice of t he r ebalancing component of t he hedg-

ing st r at egy is given by

( EQ 23)

This equat ion r epr esent s t he fact t hat a shar es posit ion, cont inuously

r ebalanced t o be wor t h $1, has a for war d pr ice t hat gr ows at t he r isk-

less r at e.

V

1

T

---- σ

2

t d

0

T

∫

≡

2

T

----

S

t

d

S

t

---------

0

T

∫

S

T

S

0

------- log – =

1/S

t

K

v ar

2

T

---- E

S

t

d

S

t

---------

0

T

∫

S

T

S

0

------- log – =

S

t

d

S

t

--------- rd t σ t … , ( )d Z + =

E

S

t

d

S

t

---------

0

T

∫

rT =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

18

As t her e ar e no act ively t r aded log cont r act s for t he second t er m in

Equat ion 21, one must duplicat e t he log payoff, at all st ock pr ice levels

at expir at ion, by decomposing it s shape int o linear and cur ved compo-

nent s, and t hen duplicat ing each of t hese separ at ely. The linear compo-

nent can be duplicat ed wit h a for war d cont r act on t he st ock wit h

deliver y t ime T; t he r emaining cur ved component , r epr esent ing t he

quadr at ic and higher or der cont r ibut ions, can be duplicat ed using st an-

dar d opt ions wit h all possible st r ike levels and t he same expir at ion

t ime T.

For pr act ical r easons we want t o duplicat e t he log payoff wit h liquid

opt ions – t hat is, wit h a combinat ion of out -of-t he-money calls for high

st ock values and out -of-t he-money put s for low st ock values. We int r o-

duce a new ar bit r ar y par amet er S

*

t o deﬁne t he boundar y bet ween

calls and put s. The log payoff can t hen be r ewr it t en as

( EQ 24)

The second t er m is const ant , independent of t he ﬁnal st ock

pr ice S

T

, so only t he ﬁr st t er m has t o be r eplicat ed.

The following mat hemat ical ident it y, which holds for all fut ur e values

of S

T

, suggest s t he decomposit ion of t he log-payoff:

( EQ 25)

Equat ion 25 r epr esent s t he decomposit ion of a log payoff int o a por t fo-

lio consist ing of:

• a shor t posit ion in for war d cont r act s st r uck at S

*

;

• a long posit ion in put opt ions st r uck at K, for all st r ikes

fr om 0 t o S

*

; and

• a similar long posit ion in call opt ions st r uck at K, for all

st r ikes fr om S

*

t o .

All cont r act s expir e at t ime T. Figur e 4 shows t his decomposit ion sche-

mat ically.

S

T

S

0

------- log

S

T

S

*

------- log

S

*

S

0

------- log + =

S

*

S

0

⁄ ( ) log

S

T

S

*

------- log –

S

T

S

*

–

S

*

-------------------- (for war d cont r act ) – =

1

K

2

-------- Max K S

T

– 0 , ( ) K d

0

S

*

∫

+ (put opt ions)

1

K

2

-------- Max S

T

K – 0 , ( ) K (call opt ions) d

S

*

∞

∫

+

1 S

*

⁄ ( )

1 K

2

⁄ ( )

1 K

2

⁄ ( )

∞

19

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

The fair value of fut ur e var iance can be r elat ed t o t he init ial fair value

of each t er m on t he r ight hand side of Equat ion 21. By using t he ident i-

t ies in Equat ions 23 and 25, we obt ain

( EQ 26)

wher e P(K) and (C(K)), r espect ively, denot e t he cur r ent fair value of a

put and call opt ion of st r ike K. If you use t he mar ket pr ices of t hese

opt ions, you obt ain an est imat e of t he cur r ent mar ket pr ice of fut ur e

var iance.

This appr oach t o t he fair value of fut ur e var iance is t he most r igor ous

fr om a t heor et ical point of view, and makes less assumpt ions t han our

int uit ive t r eat ment in t he sect ion on page 6. Equat ion 26 makes pr e-

cise t he int uit ive not ion t hat implied volat ilit ies can be r egar ded as t he

mar ket ’s expect at ion of fut ur e r ealized volat ilit ies. It pr ovides a dir ect

connect ion bet ween t he mar ket cost of opt ions and t he st r at egy for cap-

t ur ing fut ur e r ealized volat ilit y, even when there is an implied volatility

skew and t he simple Black-Scholes for mula is invalid.

K

v ar

2

T

---- rT

S

0

S

*

-------e

rT

1 –

¸ ,

¸ _

S

*

S

0

------- log – –

¸

¸

=

e

rT

1

K

2

-------- P K ( ) K d

0

S

*

∫

+

e

rT

1

K

2

--------C K ( ) K d

S

*

∞

∫ ,

_

+

FIG URE 4. Re p lic a tion of the log p a yoff. ( a ) The p a yoff of a short p osition in a

log c ontra c t a t e xp ira tion. ( b ) Da she d line : the line a r p a yoff a t e xp ira tion of

a forwa rd c ontra c t with d e live ry p ric e S

*

; Solid line : the c urve d p a yoff of

c a lls struc k a b ove S

*

a nd p uts struc k b e low S

*

. Ea c h op tion is we ig hte d by

the inve rse sq ua re of its strike . The sum of the p a yoffs for the d a she d a nd

solid line s p rovid e the sa me p a yoff a s the log c ontra c t.

S

*

S

*

S

T

S

*

------- log –

S

T

S

*

–

S

*

-------------------- –

por t folio of opt ions

( a ) ( b )

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

20

AN EXAM PLE O F A

VARIANC E SWAP

We now pr esent a det ailed pr act ical example. Suppose you want t o

pr ice a swap on t he r ealized var iance of t he daily r et ur ns of some hypo-

t het ical equit y index. The fair deliver y var iance is det er mined by t he

cost of t he r eplicat ing st r at egy discussed in t he pr evious sect ion. If you

could buy opt ions of all st r ikes bet ween zer o and inﬁnit y, t he fair var i-

ance would be given by Equat ion 26 wit h some choice of S

*

, say S

*

= S

0

.

In pr act ice, however, only a small set of discr et e opt ion st r ikes is avail-

able, and using Equat ion 26 wit h only a few st r ikes leads t o appr ecia-

ble er r or s. Her e we suggest a bet t er appr oximat ion.

We st ar t wit h t he deﬁnit ion of fair var iance given by Equat ion 21,

which can be wr it t en as

Taking expect at ions, t his becomes

( EQ 27)

wher e is t he pr esent value of t he por t folio of opt ions wit h payoff

at expir at ion given by

( EQ 28)

Suppose t hat you can t r ade call opt ions wit h st r ikes K

ic

such t hat

and put opt ions wit h st r ikes K

ip

such

t hat

In Appendix A we der ive t he for mula t hat det er mines how many

opt ions of each st r ike you need in or der t o appr oximat e t he payoff f(S

T

)

by piece-wise linear opt ions payoffs. The pr ocedur e in Appendix A

guar ant ees t hat t hese payoffs will always exceed or mat ch t he value of

t he log cont r act , but never be wor t h less. Once t hese weight s ar e calcu-

lat ed, is obt ained fr om

( EQ 29)

We now illust r at e t his pr ocedur e wit h a concr et e numer ical example.

K

v ar

2

T

---- E

S

t

d

S

t

---------

0

T

∫

S

T

S

*

–

S

*

-------------------- –

S

*

S

0

-------

S

T

S

*

–

S

*

--------------------

S

T

S

*

------- log – + log – ≡

K

v ar

2

T

---- rT

S

0

S

*

-------e

rT

1 –

¸ ,

¸ _

S

*

S

0

------- log – – e

rT

Π

CP

+ =

Π

CP

f S

T

( )

2

T

----

S

T

S

*

–

S

*

--------------------

S

T

S

*

------- log –

¸ ,

¸ _

=

K

0

S

*

K

1c

K

2c

K

3c

... < < < < =

K

0

S

*

K

1 p

K

2 p

K

3 p

... > > > > =

Π

CP

Π

CP

w K

i p

( )P S K

i p

, ( ) w K

i c

( )C S K

i c

, ( )

i

∑

+

i

∑

=

21

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

TABLE 1. The p ortfolio of Europ e a n- style p ut a nd c a ll op tions use d for

c a lc ula ting the c ost of c a p turing re a lize d va ria nc e in the p re se nc e of the

imp lie d vola tility ske w with a d isc re te se t of op tions strike s.

Assume t hat t he index level S

0

is 100, t he cont inuously compounded

annual r iskless int er est r at e r is 5%, t he dividend yield is zer o, and t he

mat ur it y of t he var iance swap is t hr ee mont hs (T = 0.25. Suppose t hat

Strike Vola tility We ig ht

Va lue

p e r

O p tion

C ontrib ution

P

U

T

S

50 30 163.04 0.000002 0.0004

55 29 134.63 0.00003 0.0035

60 28 113.05 0.0002 0.0241

65 27 96.27 0.0013 0.1289

70 26 82.98 0.0067 0.5560

75 25 72.26 0.0276 1.9939

80 24 63.49 0.0958 6.0829

85 23 56.23 0.2854 16.0459

90 22 50.15 0.7384 37.0260

95 21 45.00 1.6747 75.3616

100 20 20.98 3.3537 70.3615

C

A

L

L

S

100 20 19.63 4.5790 89.8691

105 19 36.83 2.2581 83.1580

110 18 33.55 0.8874 29.7752

115 17 30.69 0.2578 7.9130

120 16 28.19 0.0501 1.4119

125 15 25.98 0.0057 0.1476

130 14 24.02 0.0003 0.0075

135 13 22.27 0.000006 0.0001

TOTAL C O ST 419.8671

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

22

you can buy opt ions wit h st r ikes in t he r ange fr om 50 t o 150, unifor mly

spaced 5 point s apar t . We assume t hat at -t he-money implied volat ilit y

is 20%, wit h a skew such t hat t he implied volat ilit y incr eases by 1 vola-

t ilit y point for ever y 5 point decr ease in t he st r ike level. In Table 1 we

pr ovide t he list of st r ikes and t heir cor r esponding implied volat ilit ies.

We t hen show t he weight s, t he value of each individual opt ion and t he

cont r ibut ion of each st r ike level t o t he t ot al cost of t he por t folio. At t he

bot t om of t he t able we show t he t ot al cost of t he opt ions por t folio,

. It is clear fr om Table 1 t hat most of t he cost comes

fr om opt ions wit h st r ikes near t he spot value. Alt hough t he number of

opt ions which ar e far out of t he money is lar ge, t heir value is small and

cont r ibut es lit t le t o t he t ot al cost .

The cost of capt ur ing var iance is now simply calculat ed using Equat ion

27 wit h t he r esult . This is not st r ict ly t he fair var i-

ance; because t he pr ocedur e of appr oximat ing t he log cont r act in

Appendix A always over-est imat es t he value of t he log cont r act , t his

value is higher t han t he t r ue t heor et ical value for t he fair var iance

obt ained by appr oximat ing t he log cont r act wit h a cont inuum of

st r ikes. In Figur e 5 we illust r at e t he cost of var iance as funct ion of t he

spacing bet ween st r ikes, for t wo cases, wit h and wit hout a volat ilit y

skew. You can see t hat as t he spacing bet ween st r ikes appr oaches zer o,

t he cost of capt ur ing var iance appr oaches t he t heor et ically fair var i-

ance.

0 1 2 3 4 5

DK

400

405

410

415

420

K

v

a

r

FIG URE 5. C onve rg e nc e of K

va r,

the c ost of c a p turing va ria nc e with a

d isc re te se t of strike s, towa rd s the fa ir va lue of va ria nc e a s a func tion of

∆K, the sp a c ing b e twe e n strike s. The line with sq ua re symb ols shows the

c onve rg e nc e for no ske w, with a ll imp lie d vola tilitie s a t the sa me va lue of

20%. The the ore tic a l fa ir va ria nc e for ∆K = 0 is the n ( 20)

2

= 400. The line

with d ia mond symb ols shows simila r c onve rg e nc e to a hig he r fa ir

va ria nc e of a b out 402, the e xtra c ontrib ution c oming from the e ffe c t of

the ske w.

Π

CP

419.8671 =

K

v ar

20.467 ( )

2

=

23

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

EFFEC TS O F THE

VO LATILITY SKEW

The gener al st r at egy discussed in t he pr evious sect ion can be used t o

det er mine t he fair var iance and t he hedging por t folio fr om t he set of

available opt ions and t heir implied volat ilit ies. Her e we discuss t he

effect s of a volat ilit y skew on t he fair var iance. We assume t hat t her e is

no t er m st r uct ur e and consider t wo differ ent skew par amet er izat ions,

bot h of which r esemble t ypical index skews. The ﬁr st is a skew t hat

var ies linear ly wit h t he st r ike of t he opt ion, t he second a skew t hat

var ies linear ly wit h t he Black-Scholes delt a. In bot h cases we will com-

par e t he numer ically cor r ect value of fair var iance, comput ed fr om

Equat ion 26, wit h an appr oximat e analyt ic for mula t hat we der ive.

This for mula pr ovides a good r ule of t humb for a quick est imat e of t he

impact of t he volat ilit y skew on t he fair var iance.

Ske w Line a r in Strike We ﬁr st consider a skew for which t he implied volat ilit y var ies linear ly

wit h st r ike, so t hat

( EQ 30)

Her e Σ

0

is t he implied volat ilit y of an opt ion st r uck at t he for war d. The

st eepness of t he skew is det er mined by t he slope b, wit h a posit ive

value indicat ing a higher volat ilit y for st r ikes below t he for war d. Not e

t hat t his par amet r izat ion cannot hold for all st r ikes, because, for a

lar ge enough value of K, t he implied volat ilit y would become negat ive

7

.

A value of b = 0.2 means t hat t he implied volat ilit y cor r esponding t o a

st r ike 10% below t he for war d, for example, is 2 volat ilit y point s higher

t han Σ

0

. In Appendix B we der ive t he following appr oximat e for mula

for t he fair var iance of t he cont r act wit h t ime t o expir at ion T:

( EQ 31)

The skew incr eases t he value of t he fair var iance above t he at -t he-

money-for war d level of volat ilit y, and t he size of t he incr ease is pr opor -

t ional t o t ime t o mat ur it y and t he squar e of t he skew slope. (Not e t hat

b in Equat ion 30 has t he same dimension as volat ilit y, so t hat b

2

T is a

dimensionless par amet er, and t her efor e a nat ur al candidat e for t he

or der of magnit ude of t he per cent age cor r ect ion t o K

var

. Not e also t hat

t her e is no t er m in Equat ion 31. This appr oximat ion wor ks best

for shor t mat ur it ies and skews t hat ar e not t oo st eep.

7. Not e t hat for lar ge values of K, wher e t his par amet er izat ion is invalid,

t he opt ions pr ices in Equat ion 26 ar e negligible and t her efor e do not

affect t he value of t he fair var iance.

Σ K ( ) Σ

0

b

K S

F

–

S

F

------------------ – =

K

v ar

Σ

0

2

1 3T b

2

.... + + ( ) ≈

b T

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

24

In Table 2 we compar e t he exact r esult s for fair var iance, comput ed

numer ically, wit h t he appr oximat e values given by t he analyt ic for -

mula in Equat ion 31.

TABLE 2. C omp a rison of the e xa c t fa ir va ria nc e , c omp ute d nume ric a lly, with

the a p p roxima te a na lytic formula of Eq ua tion 31. We a ssume Σ

0

= 30%, S =

100, the c ontinuously c omp ound e d a nnua l d isc ount ra te r = 5%, ze ro

d ivid e nd yie ld , a nd use strike s e ve nly sp a c e d one p oint a p a rt from K = 10

to K = 200 to re p lic a te the log p a yoff.

Figur e 6 cont ains a gr aph of t hese r esult s. We see excellent agr eement

in t he case of t he t hr ee-mont h var iance swap, and r easonable agr ee-

ment for one year.

Ske w Slop e

b

T = 3 months T = 1 ye a r

Exa c t

Va lue

Ana lytic

Ap p roxima tion

Exa c t

Va lue

Ana lytic

Ap p roxima tion

0.0

0.1

0.2

0.3

30.01 ( )

2

30.00 ( )

2

29.97 ( )

2

30.00 ( )

2

30.01 ( )

2

30.11 ( )

2

30.05 ( )

2

30.45 ( )

2

30.22 ( )

2

30.44 ( )

2

30.82 ( )

2

31.75 ( )

2

30.65 ( )

2

30.99 ( )

2

32.33 ( )

2

33.81 ( )

2

0.1 0.2 0.3

b

900

950

1000

1050

1100

1150

K

v

a

r

0.1 0.2 0.3

b

900

950

1000

1050

1100

1150

K

v

a

r

FIG URE 6. C omp a rison of the e xa c t va lue of fa ir va ria nc e , K

va r

, with the

a p p roxima te va lue from the formula of Eq ua tion 31, a s a func tion of the

ske w slop e b . The thin line with sq ua re s shows the e xa c t va lue s ob ta ine d

by re p lic a ting the log - p a yoff. The thic k line d e p ic ts the a p p roxima te

va lue g ive n by Eq ua tion 31. ( a ) thre e - month va ria nc e swa p . ( b ) one - ye a r

va ria nc e swa p .

( a ) ( b )

25

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

Ske w Line a r in De lta Next we consider a skew t hat var ies linear ly wit h t he Black-Scholes

delt a of t he opt ion, so t hat :

( EQ 32)

Her e ∆

p

is t he Black-Scholes exposur e of a put opt ion, given by

, wher e d

1

is deﬁned in Foot not e 2, is t he implied

volat ilit y of a “50-delt a” put opt ion and b is t he slope of t he skew – t hat

is, t he change in t he skew per unit delt a. This par amet er b is not t he

same as t he b in t he pr evious sect ion. In par t icular, t her e is an implicit

dependence on t he t ime t o expir at ion in t he for mula of Equat ion 32,

because of t he ∆

p

t er m, which was absent fr om Equat ion 30. Since ∆

p

is

bounded, t he implied volat ilit y is always posit ive pr ovided b < 2Σ

0

.

This r est r ict ion is ir r elevant , since Equat ion 32 leads t o ar bit r age vio-

lat ion befor e b r eaches t his limit . In pr act ice, t his par amet er izat ion

leads t o mor e r ealist ic skews t han t hose pr oduced by t he linear-st r ike

for mula.

Appendix C pr esent s a det ailed der ivat ion of t he following appr oximat e

for mula for t he fair var iance of t he cont r act wit h t ime t o expir at ion T:

( EQ 33)

Her e, in cont r ast t o t he skew linear in st r ike, t he ﬁr st -or der cor r ect ion

is of magnit ude , because a var iat ion linear in delt a about t he at -

t he-money-for war d st r ike is not equivalent t o a var iat ion linear in

st r ike.

Σ ∆

p

( ) Σ

0

b ∆

p

1

2

--- +

¸ ,

¸ _

+ =

∆

p

N d

1

– ( ) – = Σ

0

K

v ar

Σ

0

2

1

1

π

-------b T

1

12

------

b

2

Σ

0

2

------ .... + + +

¸ ,

¸ _

≈

b T

-1 -0.75 -0.5 -0.25 0

∆

p

20

25

30

35

40

Σ

60 80 100 120 140

K

20

25

30

35

40

Σ

FIG URE 7. ( a ) A vola tility ske w tha t va rie s line a rly in d e lta . ( b ) The

c orre sp ond ing ske w p lotte d a s a func tion of strike . We ha ve a ssume d tha t

the stoc k p ric e S is 100, the c ontinuously c omp ound e d a nnua l d isc ount

ra te r is 5%, the te rm to ma turity is thre e months, a nd the ske w slop e is 0.2.

( a ) ( b )

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

26

Fir st , we conver t t he skew by delt a in Equat ion 32 int o a skew by

st r ike, as displayed in Figur e 7. Again, we compar e t he exact r esult s

comput ed accor ding t o Appendix A wit h t he appr oximat e values given

by Equat ion 33. In Table 3 we compar e t he r esult s for fair var iance,

comput ed numer ically, wit h t he appr oximat e values given by t he ana-

lyt ic for mula in Equat ion 33. The analyt ic for mula wor ks ver y well for

t he t hr ee-mont h var iance swap, and t r uly impr essively for t he one-

year swap, as displayed in Figur e 8.

TABLE 3. C omp a rison of the fa ir va ria nc e , c omp ute d nume ric a lly, with the

a p p roxima te a na lytic formula of Eq ua tion 33. We a ssume Σ

0

= 30%, S = 100,

the c ontinuously c omp ound e d a nnua l d isc ount ra te r = 5%, ze ro d ivid e nd

yie ld , a nd use strike s e ve nly sp a c e d one p oint a p a rt from K = 10 to K = 200

to re p lic a te the log p a yoff.

Ske w Slop e

b

T = 3 months T = 1 ye a r

Exa c t

Va lue

Ana lytic

Ap p roxima tion

Exa c t

Va lue

Ana lytic

Ap p roxima tion

0.0

0.1

0.2

0.3

30.01 ( )

2

30.00 ( )

2

29.97 ( )

2

30.00 ( )

2

30.61 ( )

2

30.62 ( )

2

31.06 ( )

2

31.03 ( )

2

31.49 ( )

2

31.60 ( )

2

32.42 ( )

2

32.40 ( )

2

32.64 ( )

2

32.93 ( )

2

34.06 ( )

2

34.06 ( )

2

0.1 0.2 0.3

b

900

950

1000

1050

1100

1150

K

v

a

r

0.1 0.2 0.3

b

900

950

1000

1050

1100

1150

K

v

a

r

FIG URE 8. C omp a rison of the e xa c t va lue of fa ir va ria nc e , K

va r

, with the

a p p roxima te va lue from the formula of Eq ua tion 33, a s a func tion of the

ske w slop e b . The thin line with sq ua re s shows the e xa c t va lue s ob ta ine d

by re p lic a ting the log - p a yoff. The thic k line d e p ic ts the a p p roxima te

va lue g ive n by Eq ua tion 33. ( a ) Thre e - month va ria nc e swa p . ( b ) O ne -

ye a r va ria nc e swa p .

( a ) ( b )

27

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

PRAC TICAL PRO BLEM S

WITH REPLICATIO N

We have shown in Equat ion 20 t hat a var iance swap is t heor et ically

equivalent t o a dynamically adjust ed, const ant -dollar exposur e t o t he

st ock, t oget her wit h a st at ic long posit ion in a por t folio of opt ions and a

for war d t hat t oget her r eplicat e t he payoff of a log cont r act . This por t fo-

lio st r at egy capt ur es var iance exact ly, pr ovided t he por t folio of opt ions

cont ains all st r ikes bet ween zer o and inﬁnit y in t he appr opr iat e weight

t o mat ch t he log payoff, and pr ovided t he st ock pr ice evolves cont inu-

ously.

Two obvious t hings can go wr ong. Fir st , you may be able t o t r ade only a

limit ed r ange of opt ions st r ikes, insufﬁcient t o accur at ely r eplicat e t he

log payoff. Second, t he st ock pr ice may jump. Bot h of t hese effect s

cause t he st r at egy t o capt ur e a quant it y t hat is not t he t r ue r ealized

var iance. We will focus on t he effect s of t hese t wo limit at ions below,

t hough ot her pr act ical issues, like liquidit y, may also cor r upt t he ideal

st r at egy.

Imp e rfe c t Re p lic a tion

Due to Limite d Strike

Ra ng e

Var iance r eplicat ion r equir es a log cont r act . Since log cont r act s ar e not

t r aded in pr act ice, we r eplicat e t he payoff wit h t r aded st andar d opt ions

in a limit ed st r ike r ange. Because t hese st r ikes fail t o duplicat e t he log

cont r act exact ly, t hey will capt ur e less t han t he t r ue r ealized var iance.

Ther efor e, t hey have lower value t han t hat of a t r ue log cont r act , and

so pr oduce an inaccur at e, lower est imat e of t he fair var iance.

In Table 4 below we show how t he est imat ed value of fair var iance is

affect ed by t he r ange of st r ikes t hat make up t he r eplicat ing por t folio.

The fair var iances ar e est imat ed fr om (1) a r eplicat ing por t folio wit h a

nar r ow r ange of st r ikes, r anging fr om 75% t o 125% of t he init ial spot

level, and (2) a por t folio wit h a wide r ange of st r ikes, fr om 50% t o 200%

of t he init ial spot level. In bot h cases t he st r ikes ar e unifor mly spaced,

one point apar t . (The fair var iance is calculat ed accor ding t o Equat ion

26, except t hat t he int egr als ar e r eplaced by sums over t he available

opt ion st r ikes whose weight s ar e chosen accor ding t o t he pr ocedur e of

Appendix A). We assume her e t hat implied volat ilit y is 25% per year

for all st r ikes, wit h no volat ilit y skew, so t hat all opt ions ar e valued at

t he same implied volat ilit y. We also assume a cont inuously com-

pounded annual int er est r at e of 5%.

For bot h expir at ions, t he wide st r ike r ange accur at ely appr oximat es

t he act ual squar e of t he implied volat ilit y. However, t he nar r ow st r ike

r ange under est imat es t he fair var iance, mor e dr amat ically so for

longer expir at ions.

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

28

TABLE 4. The e ffe c t of strike ra ng e on e stima te d fa ir va ria nc e .

In t he sect ion ent it led Replicating Variance Swaps: First Stepson page 6, we have

alr eady discussed one appr oach t o under st anding why t he nar r ow

st r ike r ange fails t o capt ur e var iance. As shown in Figur e 3, t he vega

and gamma of a limit ed st r ike r ange bot h fall t o zer o when t he index

moves out side t he st r ike r ange, and t he st r at egy t hen fails t o accr ue

r ealized var iance as t he st ock pr ice moves. Consequent ly, t he est i-

mat ed var iance is lower t han t he t r ue fair value for bot h expir at ions

above, and t he r educt ion in value is gr eat er for t he one-year case. Over

a longer t ime per iod it is mor e likely t hat t he st ock pr ice will evolve

out side t he st r ike r ange.

In essence, capt ur ing var iance r equir es owning t he full log cont r act ,

whose duplicat ion demands an inﬁnit e r ange of st r ikes. If you own a

limit ed number of st r ikes, st ill appr opr iat ely weight ed, you pay less

t han t he full value, and, when t he st ock pr ice evolves int o r egions

wher e t he cur vat ur e of t he por t folio is insufﬁcient ly lar ge, you capt ur e

less t han t he full r ealized var iance, even if no jumps occur and t he

st ock always moves cont inuously. In or der t o keep capt ur ing var iance,

you need t o maint ain t he cur vat ur e of t he log cont r act at t he cur r ent

st ock pr ice, what ever value it t akes.

A simpler way of under st anding why a nar r ow st r ike r ange leads t o a

lower fair var iance is t o compar e t he payoff of t he nar r ow-st r ike r epli-

cat ing por t folio at expir at ion t o t he t er minal payoff t hat t he por t folio is

at t empt ing t o r eplicat e, t hat is, t he nonlinear par t of t he log payoff:

( EQ 34)

Figur e 9 displays t he mismat ch bet ween t he t wo payoffs. The nar r ow-

st r ike opt ion por t folio mat ches t he cur ved par t of t he log payoff well at

st ock pr ice levels bet ween t he r ange of st r ikes, t hat is, fr om 75 t o 125.

Beyond t his r ange, t he opt ion por t folio payoff r emains linear, always

gr owing less r apidly t han t he nonlinear par t of t he log cont r act . The

lack of cur vat ur e (or gamma, or vega) in t he opt ions por t folio out side

Exp ira tion Wid e strike ra ng e

( 50% - 200%)

Na rrow strike ra ng e

( 75% - 125%)

Thr ee-mont h

One-year

25.0 ( )

2

24.9 ( )

2

25.0 ( )

2

23.0 ( )

2

S

T

S

0

–

S

0

--------------------

S

T

S

0

------- log –

29

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

t he nar r ow st r ike r ange is r esponsible for t he inabilit y t o capt ur e var i-

ance.

The Effe c t of Jump s

on a Pe rfe c tly Re p li-

c a te d Log C ontra c t

When t he st ock pr ice jumps, t he log cont r act may no longer capt ur e

r ealized volat ilit y, for t wo r easons. Fir st , if t he log cont r act has been

appr oximat ely r eplicat ed by only a ﬁnit e r ange of st r ikes, a lar ge jump

may t ake t he st ock pr ice int o a r egion in which var iance does not

accr ue at t he r ight r at e. Second, even wit h per fect r eplicat ion, a discon-

t inuous st ock-pr ice jump causes t he var iance-capt ur e st r at egy of Equa-

t ion 20 t o capt ur e an amount not equal t o t he t r ue r ealized var iance. In

r ealit y, bot h t hese effect s cont r ibut e t o t he r eplicat ion er r or. In t his sec-

t ion, we focus only on t he second effect and examine t he effect s of

jumps assuming t hat t he log-payoff can be r eplicat ed per fect ly wit h

opt ions.

For t he sake of discussion, fr om now on we will assume t hat we ar e

shor t t he var iance swap, which we will hedge by following a discr et e

ver sion of t he var iance-capt ur e st r at egy

( EQ 35)

wher e is t he change in st ock pr ice bet ween successive

obser vat ions. Rat her t han cont inuously r ebalance as t he st ock pr ice

moves, we inst ead adjust t he exposur e t o (2/T) dollar s wor t h of st ock

only when a new st ock pr ice is r ecor ded for updat ing t he r ealized var i-

ance.

Because of t he addit ive pr oper t ies of t he logar it hm funct ion, t he t er mi-

nal log payoff is equivalent t o a daily accumulat ion of log payoffs:

50 100 150 200

S

T

T

e

r

m

i

n

a

l

p

a

y

o

f

f

FIG URE 9. C omp a rison of the te rmina l p a yoff of the na rrow- strike re p lic a ting

p ortfolio ( d a she d line ) a nd the nonline a r p a rt of the log - p a yoff ( solid line ) .

V

2

T

----

∆S

i

S

i 1 –

-------------

i 1 =

N

∑

S

T

S

0

------- log – =

∆S

i

S

i

S

i 1 –

– =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

30

( EQ 36)

Suppose t hat all but one of t he daily pr ice changes ar e well-behaved –

t hat is, all changes ar e diffusive, except for a single jump event . We

char act er ize t he jump by t he par amet er , t he per cent age jump down-

wards, fr om ; a jump downwar ds of 10% cor r esponds t o J

= 0.1. A jump up cor r esponds t o a value J < 0.

The cont r ibut ion of t his one jump t o t he var iance is easy t o isolat e,

because var iance is addit ive; t he t ot al (un-annualized) r ealized var i-

ance for a zer o-mean cont r act is t he sum

( EQ 37)

The cont r ibut ion of t he jump t o t he r ealized t ot al var iance is given by:

( EQ 38)

On t he ot her hand, t he impact of t he jump on t he quant it y capt ur ed by

our var iance r eplicat ion st r at egy in Equat ion 36 is

( EQ 39)

In t he limit t hat t he jump size J is small enough t o be r egar ded as par t

of a cont inuous st ock evolut ion pr ocess, t he r ight hand side of Equat ion

39 does r educe t o t he cont r ibut ion of t his (now small) move t o t he t r ue

r ealized var iance. It is only because J is not small t hat t he var iance

capt ur e st r at egy is inaccur at e. Ther efor e, t he r eplicat ion er r or, or t he

P&L (pr oﬁt /loss) due t o t he jump for a shor t posit ion in a var iance

swap hedged by a long posit ion in a var iance-capt ur e st r at egy is

( EQ 40)

To under st and t his r esult bet t er, it is helpful t o expand t he log funct ion

as a ser ies in J :

( EQ 41)

V

2

T

----

∆S

i

S

i 1 –

-------------

S

i

S

i 1 –

------------- log –

i 1 =

N

∑

=

J

S S 1 J – ( ) →

V

1

T

----

∆S

i

S

i 1 –

-------------

¸ ,

¸ _

2

∑

1

T

----

∆S

i

S

i 1 –

-------------

¸ ,

¸ _

2

1

T

----

∆S

S

--------

¸ ,

¸ _

2

jump

+

no jumps

∑

= =

1

T

----

∆S

S

--------

¸ ,

¸ _

2

jump

J

2

T

------- =

2

T

----

∆S

i

S

i 1 –

-------------

S

i

S

i 1 –

------------- log –

¸ ,

¸ _

jump

2

T

---- J – 1 J – ( ) log – [ ] =

P&L due t o jump =

2

T

---- J – 1 J – ( ) log – [ ]

J

2

T

------- –

1 J – ( ) log – J

J

2

2

-------

J

3

3

------- … + + + =

31

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

The leading cont r ibut ion t o t he r eplicat ion er r or is t hen

( EQ 42)

The quadr at ic cont r ibut ion of t he jump is t he same for t he var iance

swap as it is for t he var iance-capt ur e st r at egy, and has no impact on

t he hedging mismat ch. The leading cor r ect ion is cubic in t he jump size

J and has a differ ent sign for upwar ds or downwar ds jumps. A lar ge

move downwar ds (J > 0) leads t o a pr oﬁt for t he (shor t var iance swap)-

(long var iance-capt ur e st r at egy), while a lar ge move upwar ds (J < 0)

leads t o a loss. Fur t her mor e, a lar ge move one day, followed by a lar ge

move in t he opposit e dir ect ion t he next day would t end t o offset each

ot her. Figur e 10 shows t he impact of t he jump on t he st r at egy for a

r ange of jump values. Not e t hat t he simple cubic appr oximat ion of

Equat ion 42 cor r ect ly pr edict s t he sign of t he P&L for all values of t he

jump size.

FIG URE 10. he imp a c t of a sing le jump on the p roﬁt or loss of a short p osition

in a va ria nc e swa p a nd a long p osition in the va ria nc e re p lic a tion stra te g y,

a s g ive n by Eq ua tion 40 a s a func tion of ( d ownwa rd ) jump size for T=1 ye a r.

Ther e is an analogy bet ween t he cancellat ion of t he quadr at ic jump

t er m in var iance r eplicat ion and t he linear jump t er m in opt ions r epli-

cat ion. When you ar e long an opt ion you ar e long linear, quadr at ic and

higher-or der dependence on t he st ock pr ice. If you ar e also shor t t he

opt ion’s delt a-hedge, t hen t he linear dependence of t he net posit ion

cancels, leaving only t he quadr at ic and higher-or der dependencies.

Because t he leading-or der t er m is quadr at ic, lar ge moves in eit her

dir ect ion beneﬁt t he posit ion; t his is pr ecisely why hedged long opt ions

posit ions capt ur e var iance. In cont r ast , in t he case of var iance r eplica-

t ion consider ed her e, t he var iance r eplicat ion st r at egy is long qua-

dr at ic, cubic and higher-or der t er ms in t he st ock pr ice, while t he

posit ion in t he var iance swap is shor t only t he quadr at ic dependence.

Now t he quadr at ic t er m in t he net posit ion cancels, leaving only cubic

and higher-or der dependencies on t he jump size. Since t he leading

P&L due t o jump =

2

3

---

J

3

T

------- … +

-20 -10 0 10 20

Jump size (downward)

-0.004

-0.002

0

0.002

0.004

0.006

I

m

p

a

c

t

o

f

j

u

m

p

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

32

t er m is cubic, t he dir ect ion of t he jump det er mines whet her t her e is a

net pr oﬁt or loss.

Table 5 displays t he pr oﬁt or loss due t o jumps of var ying sizes for

t hr ee-mont h and one-year var iance swaps.

TABLE 5. The p roﬁt/ loss d ue to a sing le jump for a short va ria nc e swa p with a

notiona l va lue of $1 p e r sq ua re d va ria nc e p oint, tha t is he d g e d with the

va ria nc e re p lic a tion stra te g y of Eq ua tion 36 for T=1 ye a r.

The Effe c t of Jump s

Whe n Re p lic a ting With

a Finite Strike Ra ng e

In pr act ice, bot h t he effect s of jumps and t he r isks of log r eplicat ion

wit h only a limit ed st r ike r ange cause t he st r at egy t o capt ur e a quan-

t it y differ ent fr om t he t r ue r ealized var iance of t he st ock pr ice. The

combined effect of bot h t hese r isks is har der t o char act er ize because

t hey int er act wit h one anot her in a complicat ed manner.

Consider again a shor t posit ion in a var iance cont r act t hat is being

hedged by t he var iance-capt ur e st r at egy. Suppose t hat a downwar d

jump occur s, lar ge enough t o move t he st ock pr ice out side t he r ange of

opt ion st r ikes. If t he log-payoff wer e r eplicat ed per fect ly, t he const ant -

dollar exposur e would cancel t he linear par t of t he st ock pr ice change,

and lead t o a convexit y gain. Alt hough t he log-payoff is not being r epli-

cat ed per fect ly, t her e is st ill a convexit y gain fr om t he jump, but it is

smaller in size. However, aft er t his jump, wit h t he st ock pr ice now out -

side t he st r ike r ange, t he vega and gamma of t he r eplicat ing por t folio

ar e now t oo low t o accr ue sufﬁcient var iance, even if no fur t her jumps

occur. In t his scenar io, t he gain fr om t he jump has t o be balanced

against t he subsequent failur e of t he hedge t o capt ur e t he smoot h var i-

ance. The net r esult s will depend on t he det ails of t he scenar io.

In cont r ast , a lar ge move upwar ds will be doubly damaging: t her e will

be convexit y loss due t o t he jump and t he hedge will not capt ur e var i-

ance if t he jump t akes t he index out side t he st r ike r ange.

Jump size a nd

d ire c tion

Thre e - month O ne - ye a r

J = 15% (down) 101.5 25.4

J = 10% (down) 28.8 7.2

J = 5% (down) 3.5 0.9

J · −5% (up) −3.2 −0.8

J = −10% (up) −24.8 −6.2

J = −20% (up) −80.9 −20.2

33

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

FRO M VARIANC E TO

VO LATILITY

C O NTRAC TS

For most of t his not e we have focused on valuing and r eplicat ing var i-

ance swaps. But most mar ket par t icipant s pr efer t o quot e levels of vol-

at ilit y r at her t han var iance, and so we now consider volat ilit y swaps.

Ther e is no simple r eplicat ion st r at egy for synt hesizing a volat ilit y

swap; it is var iance t hat emer ges nat ur ally fr om hedged opt ions t r ad-

ing. The r eplicat ion st r at egy for t he var iance swap makes no assump-

t ions about t he level of fut ur e volat ilit y, ot her t han assuming t hat t he

st ock pr ice evolves cont inuously (wit hout jumps). Changes in volat ilit y

have no effect on t he st r at egy, which st ill capt ur es t he t ot al var iance

over t he life of t he log cont r act . In cont r ast , as we will show, t he r epli-

cat ion st r at egy for a volat ilit y swap is fundament ally differ ent ; it is

affect ed by changes in volat ilit y and it s value depends on t he volat ilit y

of fut ur e r ealized volat ilit y. In essence, fr om a cont ingent claims or

der ivat ives point of view, var iance is t he pr imar y under lyer and all

ot her volat ilit y payoffs, such as volat ilit y swaps, ar e best r egar ded as

der ivat ive secur it ies on t he var iance as under lyer. Fr om t his per spec-

t ive, volat ilit y it self is a nonlinear funct ion (t he squar e r oot ) of var i-

ance and is t her efor e mor e difﬁcult , bot h t heor et ically and pr act ically,

t o value and hedge.

To illust r at e t he issues involved, let ’s consider a naive st r at egy:

appr oximat e a volat ilit y swap by st at ically holding a suit ably chosen

var iance cont r act . In or der t o appr oximat e a volat ilit y swap st r uck at

, which has payoff , we can use t he appr oximat ion

( EQ 43)

This means t hat var iance cont r act s wit h st r ike can

appr oximat e a volat ilit y swap wit h a not ional $1/(vol point ), for r eal-

ized volat ilit ies near . Wit h t his choice, t he var iance and volat ilit y

payoffs agr ee in value and volat ilit y sensit ivit y (t he ﬁr st der ivat ive

wit h r espect t o ) when . Naively, t his would also imply

t hat t he fair pr ice of fut ur e volat ilit y (t he st r ike for which t he volat ilit y

swap has zer o value) is simply t he squar e r oot of fair var iance :

(naive est imat e) ( EQ 44)

In Figur e 11 we compar e t he t wo sides of Equat ion 43 for K

vol

= 30%

for differ ent values of t he r ealized volat ilit y. We see t hat t he act ual vol-

at ilit y swap and t he appr oximat ing var iance swap differ appr eciably

K

v ol

σ

R

K

v ol

–

σ

R

K

v ol

–

1

2K

v ol

---------------- σ

R

2

K

v ol

2

– ( ) ≈

1 2K

v ol

( ) ⁄ K

v ol

2

K

v ol

σ

R

σ

R

K

v ol

=

K

v ar

K

v ol

K

v ar

=

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

34

only when t he fut ur e r ealized volat ilit y moves away fr om ; you

cannot ﬁt a line ever ywher e wit h a par abola.

The naive est imat e of Equat ions 43 and 44 is not quit e cor r ect . Wit h

t his choice, t he var iance swap payoff is always gr eat er t han t he volat il-

it y swap payoff. The mismat ch bet ween t he var iance and volat ilit y

swap payoffs in Equat ion 43, is t he

This squar e is always posit ive, so t hat wit h t his choice of t he fair deliv-

er y pr ice for volat ilit y, t he var iance swap always out per for ms t he vola-

t ilit y swap. To avoid t his ar bit r age, we should cor r ect our naive

est imat e t o make t he fair st r ike for t he volat ilit y cont r act lower t han

t he squar e r oot of t he fair st r ike for a var iance cont r act , so t hat

. In t his way, t he st r aight line in Figur e 11 will shift t o

t he left and will not always lie below t he par abola.

In or der t o est imat e t he size of t he convexit y bias, and t her efor e t he

fair st r ike for t he volat ilit y swap, it is necessar y t o make an assump-

t ion about bot h t he level and volat ilit y of fut ur e r ealized volat ilit y. In

Appendix D we est imat e t he expect ed hedging mismat ch and st at ic

hedging par amet er s under t he assumpt ion t hat fut ur e r ealized volat il-

it y is nor mally dist r ibut ed.

Dyna mic Re p lic a tion

of a Vola tility Swa p

In pr inciple, some of t he r isks inher ent in t he st at ic appr oximat ion of a

volat ilit y swap by a var iance swap could be r educed by dynamically

t r ading new var iance cont r act s t hr oughout t he life of t he volat ilit y

swap. This dynamic r eplicat ion of a volat ilit y swap by means of var i-

20 30 40

σ

R

-15

-10

-5

0

5

10

p

a

y

o

f

f

FIG URE 11. Pa yoff of a vola tility swa p ( stra ig ht line ) a nd va ria nc e swa p

( c urve d line ) a s a func tion of re a lize d vola tility, for . K

v ol

30% =

K

v ol

convexit y bias

1

2K

v ol

---------------- σ

R

K

v ol

– ( )

2

=

K

v ol

K

v ar

<

35

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

ance swaps would (in pr inciple) pr oduce t he payoff of a volat ilit y swap

independent of t he moves in fut ur e volat ilit y. This is closely analogous

t o r eplicat ing a cur ved st ock opt ion payoff by means of delt a-hedging

using t he linear under lying st ock pr ice. In pr act ice, of cour se, t her e is

no mar ket in var iance swaps liquid enough t o pr ovide a usable under -

lyer.

In t he same way t hat t he appr opr iat e opt ion hedge r at io depends on

t he assumed fut ur e volat ilit y of t he st ock, t he dynamic r eplicat ion of a

volat ilit y swap r equir es a model for t he volat ilit y of volat ilit y. Taking

t he analogy fur t her, one could imagine t hat t he st r at egy would call for

holding at ever y inst ant a “var iance-delt a” equivalent of var iance con-

t r act s t o hedge a volat ilit y der ivat ive.

The pr act ical implement at ion of t hese ideas r equir es an ar bit r age-fr ee

model for t he st ochast ic evolut ion of t he volat ilit y sur face. Due t o t he

complexit y of t he mat hemat ics involved, it is only ver y r ecent ly t hat

such models have been developed [see for example Der man and Kani

(1998) and Ledoit (1998)]. When t her e is a liquid mar ket in var iance

swaps, t hese models may be useful in hedging volat ilit y swaps and

ot her var iance der ivat ives.

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

36

C O NC LUSIO NS AND

FUTURE INNOVATIO NS

We have t r ied t o pr esent a compr ehensive and didact ic account of bot h

t he pr inciples and met hods used t o value and hedge var iance swaps.

We have explained bot h t he int uit ive and t he r igor ous appr oach t o r ep-

licat ion. In mar ket s wit h a volat ilit y skew (t he r eal wor ld for most

swaps of int er est ), t he int uit ive appr oach loses it s foot ing. Her e, using

t he r igor ous appr oach, one can st ill value var iance swaps by r eplica-

t ion. Remar kably, we have succeeded in der iving analyt ic appr oxima-

t ions t hat wor k well for t he swap value under commonly used skew

par amet er izat ions. These for mulas enable t r ader s t o updat e pr ice

quot es quickly as t he mar ket skew changes.

Ther e ar e at least t wo ar eas wher e fur t her development is welcome.

Fir st , our abilit y t o effect ively pr ice and hedge volat ilit y swaps is st ill

limit ed. To fully implement a r eplicat ion st r at egy for volat ilit y swaps,

we need a consist ent st ochast ic volat ilit y model for opt ions. Much wor k

r emains t o be done in t his ar ea.

Second, some mar ket par t icipant s pr efer t o ent er a capped var iance

swap or volat ilit y swap t hat limit s t he possible loss on t he posit ion. The

capped var iance swap has embedded in it an opt ion on r ealized var i-

ance. The development of a t r uly liquid mar ket in volat ilit y swaps, for -

war ds or fut ur es would lead t o t he possibilit y of t r ading and hedging

volat ilit y opt ions. Once again, t his r equir es a consist ent model for st o-

chast ic volat ilit y.

37

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

APPENDIX A:

REPLICATING

LO G ARITHM IC

PAYO FFS

In t his Appendix we der ive sever al r esult s concer ning t he r eplicat ion of

a logar it hmic payoff wit h por t folios of st andar d opt ions.

C onsta nt Ve g a

Re q uire s O p tions

We ig hte d Inve rse ly

Prop ortiona l to the

Sq ua re of the Strike

Consider a por t folio of st andar d opt ions

( A 1)

wher e O(S,K,v) r epr esent s a st andar d Black-Scholes opt ion of st r ike K

and t ot al var iance when t he st ock pr ice is S.

Vega, t he sensit ivit y t o t he t ot al var iance of an individual opt ion O in

t his por t folio, is given by

wher e

and

.

The var iance sensit ivit y of t he whole por t folio is t her efor e

( A 2)

The sensit ivit y of vega t o S is

Π S ( ) ρ K ( )O S K v , , ( ) K d

0

∞

∫

=

v σ

2

τ =

V

O

τ

v ∂

∂

O ( ) τS f

K

S

----- v ,

¸ ,

¸ _

= =

f S K v , , ( )

1

2 v

-----------

d

1

2

2 ⁄ – ( ) exp

2π

-------------------------------- =

d

1

S K ⁄ ( ) ln v 2 ⁄ +

v

----------------------------------------- =

V

Π

S ( ) τ ρ K ( )S f

K

S

----- v ,

¸ ,

¸ _

K d

0

∞

∫

=

S ∂

∂V

Π

τ

S ∂

∂

S

2

ρ xS ( ) [ ] f x v , ( ) x d

0

∞

∫

=

τ S 2ρ xS ( ) xS ρ' xS ( ) + [ ] f x v , ( ) x d

0

∞

∫

=

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

38

wher e, in t he second line of t he above equat ion, we changed t he int e-

gr at ion var iable t o .

We want vega t o be independent of S, t hat is , which implies

t hat

The solut ion t o t his equat ion is

( A 3)

Log Pa yoff Re p lic a tion

with a Disc re te Se t of

O p tions

It was shown in t he main t ext t hat t he r ealized var iance is r elat ed t o

t r ading a log cont r act . Since t her e is no log-cont r act t r aded, we want t o

r epr esent it in t er ms of st andar d opt ions. It is useful t o subt r act t he

linear par t (cor r esponding t o t he for war d cont r act ) and look at t he

funct ion

( A 4)

wher e S

*

is some r efer ence pr ice. In pr act ice, only a discr et e set of

opt ion st r ikes is available for r eplicat ing , and we need t o det er -

mine t he number of opt ions for each st r ike. Assume t hat you can t r ade

call opt ions wit h st r ikes

and put opt ions wit h st r ikes

We can appr oximat e wit h a piece-wise linear funct ion as in Fig-

ur e 11. The ﬁr st segment t o t he r ight of S

*

is equivalent t o t he payoff of

a call opt ion wit h st r ike K

0

. The number of opt ions is det er mined by

t he slope of t his segment :

( A 5)

x K S ⁄ =

S ∂

∂V

Π

0 =

2ρ K

K ∂

∂ρ

+ 0 =

ρ

const

K

2

-------------- =

f S

T

( )

2

T

----

S

T

S

*

–

S

*

--------------------

S

T

S

*

------- log – =

f S

T

( )

K

0

S

*

K

1c

K

2c

K

3c

... < < < < =

K

0

S

*

K

1 p

K

2 p

K

3 p

... > > > > =

f S

T

( )

w

c

K

0

( )

f K

1c

( ) f K

0

( ) –

K

1c

K

0

–

----------------------------------------- =

39

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

FIG URE 12. Log - p a yoff a nd op tions p ortfolio a t ma turity.

Similar ly, t he second segment looks like a combinat ion of calls wit h

st r ikes and . Given t hat we alr eady hold opt ions wit h

st r ike we need t o hold calls wit h st r ike wher e

( A 6)

Cont inuing in t his way we can build t he ent ir e payoff cur ve one st ep at

t he t ime. In gener al, t he number of call opt ions of st r ike is given

by

( A 7)

The ot her side of t he cur ve can be built using put opt ions:

( A 8)

K

2p

K

1p

K

0

K

1c

K

2c

K

0

K

1c

w

c

K

0

( )

K

0

w

c

K

1

( ) K

1

w

c

K

1

( )

f K

2c

( ) f K

1c

( ) –

K

2c

K

1c

–

------------------------------------------- w

c

K

0

( ) – =

K

n c ,

w

c

K

n c ,

( )

f K

n 1 c , +

( ) f K

n c ,

( ) –

K

n 1 c , +

K

n c ,

–

-------------------------------------------------------- w

c

K

i c ,

( )

i 0 =

n 1 –

∑

– =

w

p

K

n p ,

( )

f K

n 1 p , +

( ) f K

n p ,

( ) –

K

n p ,

K

n 1 + p ,

–

----------------------------------------------------------- w

c

K

i p ,

( )

i 0 =

n 1 –

∑

– =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

40

APPENDIX B:

SKEW LINEAR IN STRIKE

Her e, we der ive a for mula which gives t he appr oximat e value of t he

var iance swap when t he skew is linear in st r ike. We par amet er ize t he

implied volat ilit y by

( B 1)

wher e is t he for war d value cor r esponding t o t he cur r ent

spot , is at -t he-money for war d implied volat ilit y and is t he slope of

t he skew.

We st ar t wit h t he gener al expr ession for t he fair var iance discussed in

t he main t ext :

( B 2)

We now expand opt ion pr ices as a power ser ies in ar ound a ﬂat

implied volat ilit y ( ),

( B 3)

Using t his expansion we can for mally wr it e an expansion of fair var i-

ance in power s of as follows:

( B 4)

Σ K ( ) Σ

0

b

K S

F

–

S

F

------------------ – =

S

F

S

0

e

rT

=

Σ

0

b

K

v ar

2

T

---- rT

S

0

S

*

-------e

rT

1 –

¸ ,

¸ _

S

*

S

0

------- log – + –

¸

¸

=

e

rT 1

K

2

-------- P K Σ b ( ) , ( ) K d

0

S

*

∫

e

rT

+

1

K

2

--------C K Σ b ( ) , ( ) K d

S

*

∞

∫ ,

_

b

b 0 =

C K Σ b ( ) , ( ) C K Σ

0

, ( ) b

b ∂

∂C

b 0 =

1

2

---b

2

b

2

2

∂

∂ C

b 0 =

... + + + =

P K Σ b ( ) , ( ) P K Σ

0

, ( ) b

b ∂

∂P

b 0 =

1

2

---b

2

b

2

2

∂

∂ P

b 0 =

... + + + =

b

K

v ar

Σ

0

2

b

2

T

----e

rT

¸ ,

¸ _

1

K

2

--------

b ∂

∂P

b 0 =

K d

0

S

*

∫

1

K

2

--------

b ∂

∂C

b 0 =

K d

S

*

∞

∫

+

¹ ¹

' ;

¹ ¹

+ + =

1

2

---b

2 2

T

----e

rT

¸ ,

¸ _

1

K

2

--------

b

2

2

∂

∂ P

b 0 =

K d

0

S

*

∫

1

K

2

--------

b

2

2

∂

∂ C

b 0 =

K d

S

*

∞

∫

+

¹ ¹

¹ ¹

' ;

¹ ¹

¹ ¹

... +

41

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

Her e is t he fair var iance in t he “ﬂat wor ld” wher e volat ilit y is con-

st ant and is given by Equat ion B2 wit h r eplaced by .

The der ivat ives which ent er Equat ion B4 ar e given by

The der ivat ives wit h r espect t o volat ilit y ar e easily calculat ed using

t he Black-Scholes for mula

( B 5)

wher e, for t he model we ar e consider ing her e

( B 6)

The fact t hat call and put opt ions have t he same vega in t he Black-

Scholes fr amewor k makes it possible t o combine t he int egr als in Equa-

t ion B4 int o one int egr al fr om 0 t o :

( B 7)

Σ

0

2

Σ b ( ) Σ

0

b ∂

∂P

b 0 =

Σ ∂

∂P

Σ

0

b ∂

∂Σ

b 0 =

, =

b

2

2

∂

∂ P

b 0 =

Σ

2

2

∂

∂ P

Σ

0

b ∂

∂Σ

¸ ,

¸ _

2

b 0 =

=

b ∂

∂C

b 0 =

Σ ∂

∂C

Σ

0

b ∂

∂Σ

b 0 =

, =

b

2

2

∂

∂ C

b 0 =

Σ

2

2

∂

∂ C

Σ

0

b ∂

∂Σ

¸ ,

¸ _

2

b 0 =

=

Σ ∂

∂P

Σ

0

Σ ∂

∂C

Σ

0

S T

2π

------------e

d

1

2

2 ⁄ –

= =

Σ

2

2

∂

∂ P

Σ

0

Σ

2

2

∂

∂ C

Σ

0

S T

2π

------------d

1

Σ

0

∂

∂d

1

e

d

1

2

2 ⁄ –

– = =

d

1

S

F

K

-------

¸ ,

¸ _

1

2

---Σ

0

2

T + log

Σ

0

T

------------------------------------------- =

b ∂

∂Σ

b 0 =

K

S

F

------- 1 –

¸ ,

¸ _

– =

∞

K

v ar

Σ

0

2

b

2

T

----e

rT

¸ ,

¸ _

S T

2π

------------

1

K

2

--------

K

S

F

------- 1 –

¸ ,

¸ _

e

d

1

2

2 ⁄ –

K d

0

∞

∫

– – =

1

2

---b

2 2

T

----e

rT

¸ ,

¸ _

S T

2π

------------

1

K

2

--------

K

S

F

------- 1 –

¸ ,

¸ _

2

d

1

Σ

0

∂

∂d

1

e

d

1

2

2 ⁄ –

K d

0

∞

∫

... +

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

42

To evaluat e t hese int egr als, one can, for example, change t he int egr a-

t ion var iable t o , wher e , and

t hen wr it e Equat ion B7 as

The t er m linear in vanishes and t he t er m quadr at ic in has coefﬁ-

cient , so t hat

( B 8)

We now pr esent an alt er nat ive der ivat ion of t his r esult . We st ar t wit h

t he fundament al deﬁnit ion of t he fair deliver y var iance as t he expect ed

value of fut ur e r ealized var iance, i.e.

( B 9)

This can be evaluat ed appr oximat ely as follows. Fir st , we use t he r ela-

t ion bet ween implied and local volat ilit y:

( B 10)

Denot e . Equat ion B10 can be wr it t en as

( B 11)

z

S

F

K

------- log

1

2

---v

0

+

¸ ,

¸ _

v

0

⁄ d

1

≡ = v

0

Σ

0

2

T =

K

v ar

Σ

0

2

b 2Σ

0

1 e

v

0

z v

0

2 ⁄ –

–

¸ ,

¸ _

e

z

2

2 ⁄ – d z

2π

-----------

∞ –

∞

∫

¹ ¹

' ;

¹ ¹

– + =

b

2

e

v

0

z v

0

2 ⁄ –

e

v

0

– z v

0

2 ⁄ +

2 – +

¸ ,

¸ _

z

2

v

0

z – ( )e

z

2

2 ⁄ – d z

2π

-----------

∞ –

∞

∫

¹ ¹

' ;

¹ ¹

b b

3Σ

0

2

T

K

v ar

Σ

0

2

1 3T b

2

.... + + ( ) =

K

v ar

E

1

T

---- σ

2

S t , ( ) t d

0

T

∫

=

σ

2

S t , ( )

Σ

T

---- 2

T ∂

∂Σ

2rK

K ∂

∂Σ

+ +

K

2

K

2

2

∂

∂ Σ

d

1

T

K ∂

∂Σ

¸ ,

¸ _

2

1

Σ

---

1

K T

-------------- d

1

K ∂

∂Σ

+

¸ ,

¸ _

2

+ –

¹ ¹

' ;

¹ ¹

------------------------------------------------------------------------------------------------------------------------

K S =

T t =

=

x

S

S

F

------- 1 – =

σ

2

S t , ( )

Σ

0

bx – 2br 1 x + ( )t –

1 x + ( )

2

t b

2

t d

1

–

1

Σ

0

bx –

-------------------

1

1 x + ( ) t

------------------------ bd

1

–

2

+

¹ ¹

' ;

¹ ¹

---------------------------------------------------------------------------------------------------------------------------------- =

43

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

wher e

( B 12)

We expand in power s of and calculat e t he expect ed value in

a lognor mal wor ld wit h volat ilit y using

Expect ed values of higher power s of ar e easily calculat ed using

Aft er aver aging over t he st ock pr ice dist r ibut ion, we aver age over t ime

and, ﬁnally, expand t he r esult in power s of t he skew slope . Tedious

calculat ion leads t o t he r elat ion

It is r eassur ing t hat t hese t wo ver y differ ent met hods lead t o t he same

appr oximat ion for mula.

d

1

1 x + ( ) log –

Σ

0

bx – ( ) t

------------------------------

1

2

--- Σ

0

bx – ( ) t + =

σ

2

S t , ( ) x

Σ

0

E x [ ] 0 =

E x

2

[ ] e

Σ

0

2

t

1 – =

E x

3

[ ] e

3Σ

0

2

t

3e

Σ

0

2

t

– 2 + =

...

x

E

S

S

F

-------

¸ ,

¸ _

n

e

n

2

n – ( )Σ

0

2

t 2 ⁄

=

b

K

v ar

Σ

0

2

1 3T b

2

.... + + ( ) =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

44

APPENDIX C :

SKEW LINEAR IN DELTA

Her e we consider t he case wher e implied volat ilit y var ies linear ly wit h

delt a. Such a skew can be par amet er ized in t er ms of , t he delt a of a

Eur opean-st yle put , as

( C 1)

wher e is t he implied volat ilit y of opt ions wit h (t he “50-

delt a volat ilit y”). (We could also par amet r ize t he skew in t er ms of t he

call delt a as .)

To der ive t he for mula for t he fair var iance we follow t he same pr oce-

dur e as in Appendix B, st ar t ing wit h Equat ion B2. One impor t ant dif-

fer ence is t hat now implied volat ilit y is nonlinear in (since

depends implicit ly on ) so t hat second der ivat ives have an addit ional

t er m:

( C 2)

Ot her der ivat ives we need ar e easily calculat ed:

( C 3)

wher e

and

∆

p

Σ ∆

p

( ) Σ

0

b ∆

p

1

2

--- +

¸ ,

¸ _

+ =

Σ

0

∆

p

1 2 ⁄ – =

Σ ∆

c

( ) Σ

0

b ∆

c

1

2

--- –

¸ ,

¸ _

+ =

b ∆

p

b

b

2

2

∂

∂ P

b 0 =

Σ

2

2

∂

∂ P

Σ

0

b ∂

∂Σ

¸ ,

¸ _

2

b 0 =

Σ ∂

∂P

Σ

0

b

2

2

∂

∂ Σ

b 0 =

+ =

b

2

2

∂

∂ C

b 0 =

Σ

2

2

∂

∂ C

Σ

0

b ∂

∂Σ

¸ ,

¸ _

2

b 0 =

Σ ∂

∂C

Σ

0

b

2

2

∂

∂ Σ

b 0 =

+ =

b ∂

∂Σ

b 0 =

∆

p

1

2

--- + =

b

2

2

∂

∂ Σ

b 0 =

2 ∆

p

1

2

--- +

¸ ,

¸ _

Σ

0

∂

∂∆

p

=

∆

p

N d

1

– ( ) – =

45

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

Combining t hese r elat ions, t he fair var iance can be wr it t en as

( C 4)

Again, int egr als can be evaluat ed by changing t he int egr at ion var iable

t o , wher e , so t hat

All t hese int egr als can be evaluat ed exact ly. Since we ar e event ually

int er est ed in expanding t he r esult in power s of , one can ﬁr st

expand in power s of and int egr at e t er m by t er m. It is also

useful t o not e t hat is ant isymmet r ic in t o simplify calcula-

t ions. In addit ion t he following r esult s ar e useful:

d

1

S

F

K

------- log

Σ

0

T

----------------

1

2

---Σ

0

T + =

K

v ar

Σ

0

2

b

2

T

----e

rT

¸ ,

¸ _

S T

2π

------------

1

K

2

--------

0

∞

∫

∆

p

1

2

--- +

¸ ,

¸ _

e

d

1

2

2 ⁄ –

K d – – =

1

2

---b

2 2

T

----e

rT

¸ ,

¸ _

S T

2π

------------

1

K

2

-------- ∆

p

1

2

--- +

¸ ,

¸ _

2

d

1

Σ

0

∂

∂d

1

e

d

1

2

2 ⁄ –

K d

0

∞

∫

¸

¸

2

1

K

2

-------- ∆

p

1

2

--- +

¸ ,

¸ _

Σ

0

∂

∂∆

p

e

d

1

2

2 ⁄ –

K d

0

∞

∫

–

,

_

z

S

F

K

------- log

1

2

---v

0

+

¸ ,

¸ _

v

0

⁄ d

1

≡ = v

0

Σ

0

2

T =

K

v ar

Σ

0

2

b 2Σ

0

N z ( )

1

2

--- –

∞ –

∞

∫

e

v

0

z v

0

2 ⁄ –

e

z

2

2 ⁄ –

d z

2π

-----------

¹ ¹

¹ ¹

' ;

¹ ¹

¹ ¹

– + =

b

2

N z ( )

1

2

--- –

2

z

2

v

0

z – ( )e

v

0

z v

0

2 ⁄ –

e

z

2

2 ⁄ –

d z

2π

-----------

∞ –

∞

∫

¸

¸

2 N z ( )

1

2

--- – z v

0

– ( )e

v

0

z v

0

2 ⁄ –

e

z

2

– d z

2π

------

∞ –

∞

∫

–

,

_

v

0

Σ

0

2

T =

e

v

0

z v

0

2 ⁄ –

z

N z ( )

1

2

--- – z

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

46

( C 5)

Aft er evaluat ing all int egr als we ﬁnd t he ﬁnal answer t o be

( C 6)

Two- Slop e M od e l Our calculat ions can easily be gener alized t o t he model wher e t he slope

of t he skew is differ ent for put and call opt ions, i.e.

( C 7)

We now br ieﬂy sket ch t he der ivat ion emphasizing only t he differ ences

wit h t he above det ailed calculat ions. We st ar t wit h t he same funda-

ment al expr ession:

( C 8)

z

2n

e

az

2

2 ⁄ –

0

∞

∫

N bz ( )

1

2

--- –

d z

2π

-----------

2 – ( )

n

2π

--------------

a

n

n

∂

∂ 1

a

------- ar ct an

b

a

------- =

z

2n 1 +

e

az

2

2 ⁄ –

0

∞

∫

N bz ( )

1

2

--- –

d z

2π

-----------

2 – ( )

n

b

2 2π

------------------

a

n

n

∂

∂ 1

a a b

2

+

------------------------ =

z

2n

e

az

2

2 ⁄ –

0

∞

∫

N bz ( )

1

2

--- –

2

d z

2π

-----------

2 – ( )

n

2π

--------------

a

n

n

∂

∂ 1

a

------- ar ct an

a 2b

2

+

a

------------------------

π

4

--- –

¸ ,

¸ _

=

z

2n 1 +

e

az

2

2 ⁄ –

0

∞

∫

N bz ( )

1

2

--- –

2

d z

2π

-----------

2 – ( )

n

b

2π ( )

3 2 ⁄

--------------------

a

n

n

∂

∂ 1

a a b

2

+

------------------------ ar ct an

b

a b

2

+

--------------------

¸ ,

¸ _

=

K

v ar

Σ

0

2

bΣ

0

2 T

π

----

1

12

------b

2

.... + + + =

Σ

p

∆

p

( ) Σ

0

b

p

∆

p

1

2

--- +

¸ ,

¸ _

+ = for

1

2

--- – ∆

p

0 ≤ ≤

Σ

c

∆

c

( ) Σ

0

b

c

∆

c

1

2

--- –

¸ ,

¸ _

+ = for 0 ∆

c

1

2

--- ≤ ≤

K

v ar

2

T

---- rT

S

0

S

*

-------e

rT

1 –

¸ ,

¸ _

S

*

S

0

------- log – + –

¸

¸

=

e

rT 1

K

2

-------- P K Σ

p

b

p

( ) , ( ) K d

0

S

*

∫

e

rT

+

1

K

2

--------C K Σ

c

b

c

( ) , ( ) K d

S

*

∞

∫ ,

_

47

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

We use differ ent implied volat ilit y par amet er izat ions for put and call

opt ions, as given by Equat ion C7. Not e t hat we should choose S

*

so

t hat

This ensur es t hat we use t he put (call) par amet er izat ion in Equat ion

C7 for st r ikes below (above) S

*.

We expand put opt ion pr ices in power s

of and call opt ion pr ices in power s of . Evaluat ing all int egr als as

above we ﬁnd

( C 9)

Obviously, for t his r educes t o t he r esult for single slope given

in Equat ion C6. Not e t hat by changing t he sign of we t ur n t he

implied skew int o a smile.

S

*

S

F

e

Σ

0

2

T 2 ⁄ –

=

b

p

b

c

K

v ar

Σ

0

2 1

4

---Σ

0

b

p

b

c

– ( ) Σ

0

b

p

b

c

+

2

------------------- Σ

0

T

π

----

¸ ,

¸ _

+

1

12

------

b

p

2

b

c

2

+

2

------------------- .... + + + =

b

p

b

c

=

b

c

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

48

APPENDIX D:

STATIC AND DYNAM IC

REPLICATIO N O F A

VO LATILITY SWAP

We have ar gued t hat volat ilit y swaps ar e fundament ally differ ent fr om

var iance swaps and t hat , unlike t he var iance swap, t her e is no simple

r eplicat ing st r at egy t o synt het ically cr eat e a volat ilit y swap.

In t he sect ion From Variance to Volatility Contracts on page 33, we showed t hat

at t empt ing t o cr eat e a volat ilit y swap fr om a var iance swap by means

of a “buy-and-hold” st r at egy invar iably leads t o misr eplicat ion, since

t his amount s t o t r ying t o ﬁt a linear payoff (t he volat ilit y payoff) wit h a

quadr at ic payoff (t he var iance swap).

Given a view on bot h t he dir ect ion and volat ilit y of fut ur e volat ilit y, we

will show t hat it is possible t o pick t he st r ike and not ional size of a

var iance cont r act t o mat ch t he payoff of a volat ilit y cont r act , on aver -

age, as closely as possible. The ext ent of t he r eplicat ion mismat ch will

depend on how close t he r ealized volat ilit y is t o it s expect ed value.

The hedging inst r ument is t he r ealized var iance ( ), while t he t ar get

of t he r eplicat ion is t he r ealized volat ilit y ( ). We want t o appr oxi-

mat e t he volat ilit y as a funct ion of t he var iance by wr it ing

( D 1)

and choose a and b t o minimize t he expect ed squar ed deviat ion of t he

t wo sides of Equat ion D1:

( D 2)

Differ ent iat ion leads t o t he following equat ions for t he coefﬁcient s

and :

( D 3)

The dist r ibut ion of fut ur e volat ilit y could be assumed t o be nor mal,

wit h mean and st andar d deviat ion :

( D 4)

This model only makes sense if t he pr obabilit y of negat ive volat ilit ies

is negligible. This st r at egy will r eplicat e only on aver age; t he expect ed

squar ed r eplicat ion er r or is given by:

Σ

T

2

Σ

T

Σ

T

aΣ

T

2

b + ≈

min E Σ

T

aΣ

T

2

– b – ( )

2

[ ]

a

b

E Σ

T

[ ] aE Σ

T

2

[ ] b

E Σ

T

3

[ ]

+

aE Σ

T

4

[ ] bE Σ

T

2

[ ] +

=

=

Σ σ

Σ

Σ

T

N Σ σ

Σ

, ( ) ∼

49

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

( D 5)

For r ealized volat ilit ies dist r ibut ed nor mally as in Equat ion D4, t he

hedging coefﬁcient s ar e

( D 6)

and t he expect ed squar ed r eplicat ion er r or is:

( D 7)

min E Σ

T

aΣ

T

2

– b – ( )

2

[ ] Var Σ

T

( ) 1 cor r Σ

T

Σ

T

2

, ( ) ( )

2

– [ ] =

a

1

2Σ

σ

Σ

2

Σ

------- +

--------------------

b

Σ

2

σ

Σ

2

Σ

2

------- +

-----------------

=

=

min E Σ

T

aΣ

T

2

– b – ( )

2

[ ]

σ

Σ

2

1

2Σ

2

σ

Σ

2

---------- +

-------------------- =

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

50

REFERENC ES Car r, P. and D. Madan (1998). Towar ds a Theor y of Volat ilit y Tr ading,

in Volat ilit y: New Est imat ion Techniques for Pr icing Der ivat ives,

edit ed by R. J ar r ow, 417-427.

Der man, E. and I. Kani (1994). Riding on a Smile, RIS K 7, No. 2, 32-39.

Der man, E., I. Kani and J. Zou (1996). The Local Volat ilit y Sur face,

Financial Analyst Journal, J uly/ August, 25-36.

Der man, E., M. Kamal, I. Kani, and J. Zou (1996). Valuing Contracts

with Payoffs Based on Realized Volatility, Global Der ivat ives (J uly)

Quar t er ly Review, Equit y Der ivat ives Resear ch, Goldman, Sachs & Co.

Der man, E., M. Kamal, I. Kani, J. McClur e, C. Pir ast eh, and J. Zou

(1996). Investing in Volatility, Quant it at ive St r at egies Resear ch Not es,

Oct ober, Goldman, Sachs & Co.

Der man, E. and I. Kani (1998). St ochast ic Implied Tr ees: Ar bit r age

Pr icing wit h St ochast ic Ter m and St r ike St r uct ur e of Volat ilit y, Inter-

national Journal of Theoretical and Applied Finance, Vol. 1, No. 1, 61-

110.

Dupir e, B. (1994). Pr icing wit h a Smile, RIS K 7, No. 1, 18-20.

Ledoit , O. and P. Sant a-Clar a (1998). Relat ive Pr ice of Opt ions wit h

St ochast ic Volat ilit y. Wor king Paper, The Ander son Gr aduat e Schools

of Management , Univer sit y of Califor nia, Los Angeles.

Neuber ger, A. (1994). The Log Cont r act : A new inst r ument t o hedge

volat ilit y, Journal of Portfolio Management, Winter, 74-80.

Neuber ger, A. (1996). The Log Cont r act and Ot her Power Cont r act s, in

The Handbook of Exot ic Opt ions, edit ed by I. Nelken, 200-212.

51

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

SELECTED QUANTITATIVE STRATEGIES PUBLICATIONS

J une 1990 Understanding Guaranteed Exchange-Rate

Contracts In Foreign S tock Investments

Emanuel Der man, Piot r Kar asinski and J effr ey Wecker

J an. 1992 Valuing and Hedging Outperformance Options

Emanuel Der man

Mar. 1992 Pay-On-Exercise Options

Emanuel Der man and Ir aj Kani

J une 1993 The Ins and Outs of Barrier Options

Emanuel Der man and Ir aj Kani

J an. 1994 The Volatility S mile and Its Implied Tree

Emanuel Der man and Ir aj Kani

May 1994 S tatic Options Replication

Emanuel Der man, Deniz Er gener and Ir aj Kani

May 1995 Enhanced Numerical Methods for Options

with Barriers

Emanuel Der man, Ir aj Kani, Deniz Er gener

and Indr ajit Bar dhan

Dec. 1995 The Local Volatility S urface: Unlocking the

Information in Index Option Prices

Emanuel Der man, Ir aj Kani and J oseph Z. Zou

Feb. 1996 Implied Trinomial Trees of the Volatility S mile

Emanuel Der man, Ir aj Kani and Neil Chr iss

Apr. 1996 Model Risk

Emanuel Der man,

Aug. 1996 Trading and Hedging Local Volatility

Ir aj Kani, Emanuel Der man and Michael Kamal

Oct . 1996 Investing in Volatility

Emanuel Der man, Michael Kamal, Ir aj Kani,

J ohn McClur e, Cyr us Pir ast eh and J oseph Zou

QUANTITATIVE STRATEGIES RESEARCH NOTES

Sac hs

Goldman

52

Apr. 1997 Is the Volatility S kew Fair?

Emanuel Der man, Michael Kamal, Ir aj Kani

and J oseph Zou

Apr. 1997 S tochastic Implied Trees: Arbitrage Pricing with

S tochastic Term and S trike S tructure of Volatility

Emanuel Der man and Ir aj Kani

Sept . 1997 The Patterns of Change in Implied Index Volatilities

Michael Kamal and Emanuel Der man

Nov. 1997 Predicting the Response of Implied Volatility to Large

Index Moves: An October 1997 S &P Case S tudy

Emanuel Der man and J oe Zou

Sept . 1998 How to Value and Hedge Options on Foreign Indexes

Kr esimir Demet er ﬁ

J an. 1999 Regimes of Volatility: S ome Observations on the

Variation of S &P 500 Implied Volatilities

Emanuel Der man

Goldman Sachs

QUANTITATIVE STRATEGIES RESEARCH NOTES

Copyright 1999 Goldman, Sachs & Co. All rights reserved. This material is for your private information, and we are not soliciting any action based upon it. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. Certain transactions, including those involving futures, options and high yield securities, give rise to substantial risk and are not suitable for all investors. Opinions expressed are our present opinions only. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. We, our afﬁliates, or persons involved in the preparation or issuance of this material, may from time to time have long or short positions and buy or sell securities, futures or options identical with or related to those mentioned herein. This material has been issued by Goldman, Sachs & Co. and/or one of its afﬁliates and has been approved by Goldman Sachs International, regulated by The Securities and Futures Authority, in connection with its distribution in the United Kingdom and by Goldman Sachs Canada in connection with its distribution in Canada. This material is distributed in Hong Kong by Goldman Sachs (Asia) L.L.C., and in Japan by Goldman Sachs (Japan) Ltd. This material is not for distribution to private customers, as deﬁned by the rules of The Securities and Futures Authority in the United Kingdom, and any investments including any convertible bonds or derivatives mentioned in this material will not be made available by us to any such private customer. Neither Goldman, Sachs & Co. nor its representative in Seoul, Korea is licensed to engage in securities business in the Republic of Korea. Goldman Sachs International or its afﬁliates may have acted upon or used this research prior to or immediately following its publication. Foreign currency denominated securities are subject to ﬂuctuations in exchange rates that could have an adverse effect on the value or price of or income derived from the investment. Further information on any of the securities mentioned in this material may be obtained upon request and for this purpose persons in Italy should contact Goldman Sachs S.I.M. S.p.A. in Milan, or at its London branch ofﬁce at 133 Fleet Street, and persons in Hong Kong should contact Goldman Sachs Asia L.L.C. at 3 Garden Road. Unless governing law permits otherwise, you must contact a Goldman Sachs entity in your home jurisdiction if you want to use our services in effecting a transaction in the securities mentioned in this material. Note: Options are not suitable for all investors. Please ensure that you have read and understood the current options disclosure document before entering into any options transactions.

-2

Goldman Sachs

QUANTITATIVE STRATEGIES RESEARCH NOTES

SUMMARY Volatility swaps are forward contracts on future realized stock volatility. Variance swaps are similar contracts on variance, the square of future volatility. Both of these instruments provide an easy way for investors to gain exposure to the future level of volatility. Unlike a stock option, whose volatility exposure is contaminated by its stock-price dependence, these swaps provide pure exposure to volatility alone. You can use these instruments to speculate on future volatility levels, to trade the spread between realized and implied volatility, or to hedge the volatility exposure of other positions or businesses. In this report we explain the properties and the theory of both variance and volatility swaps, ﬁrst from an intuitive point of view and then more rigorously. The theory of variance swaps is more straightforward. We show how a variance swap can be theoretically replicated by a hedged portfolio of standard options with suitably chosen strikes, as long as stock prices evolve without jumps. The fair value of the variance swap is the cost of the replicating portfolio. We derive analytic formulas for theoretical fair value in the presence of realistic volatility skews. These formulas can be used to estimate swap values quickly as the skew changes. We then examine the modiﬁcations to these theoretical results when reality intrudes, for example when some necessary strikes are unavailable, or when stock prices undergo jumps. Finally, we brieﬂy return to volatility swaps, and show that they can be replicated by dynamically trading the more straightforward variance swap. As a result, the value of the volatility swap depends on the volatility of volatility itself. _________________ Kresimir Demeterﬁ Emanuel Derman Michael Kamal Joseph Zou _________________ Acknowledgments: We thank Emmanuel Boussard, Llewellyn Connolly, Rustom Khandalavala, Cyrus Pirasteh, David Rogers, Emmanuel Roman, Peter Selman, Richard Sussman, Nicholas Warren and several of our clients for many discussions and insightful questions about volatility swaps. _________________ Editorial: Barbara Dunn (212) 357-4611 (212) 902-0129 (212) 357-3722 (212) 902-9794

-1

Goldman Sachs

**QUANTITATIVE STRATEGIES RESEARCH NOTES
**

Table of Contents

INTRODUCTION ......................................................................................... 1 Volatility Swaps ........................................................................... 1 Who Can Use Volatility Swaps? ................................................. 2 Variance Swaps ............................................................................ 3 Outline .......................................................................................... 4 I. REPLICATING VARIANCE SWAPS: FIRST STEPS ...................................... 6 The Intuitive Approach ............................................................... 6 Trading Realized Volatility with a Log Contract ..................... 11 The Vega, Gamma and Theta of a Log Contract ...................... 11 Imperfect Hedges ...................................................................... 13 The Limitations of the Intuitive Approach .............................. 13 II. REPLICATING VARIANCE SWAPS: GENERAL RESULTS ....................... 15 Valuing and Pricing the Variance Swap.................................. 17 III. AN EXAMPLE OF A VARIANCE SWAP ................................................ 20 IV. EFFECTS OF THE VOLATILITY SKEW ................................................ 23 Skew Linear in Strike ............................................................... 23 Skew Linear in Delta ................................................................ 25 V. PRACTICAL PROBLEMS WITH REPLICATION ....................................... 27 Imperfect Replication Due to Limited Strike Range ............... 27 The Effect of Jumps on a Perfectly Replicated Log Contract .. 29 The Effect of Jumps When Replicating With a Finite Strike Range.............................................................. 32 VI. FROM VARIANCE TO VOLATILITY CONTRACTS ................................. 33 Dynamic Replication of a Volatility Swap ............................... 34 CONCLUSIONS AND FUTURE INNOVATIONS ............................................ 36 APPENDIX A: REPLICATING LOGARITHMIC PAYOFFS .............................. 37 APPENDIX B: SKEW LINEAR IN STRIKE .................................................. 40 APPENDIX C: SKEW LINEAR IN DELTA ................................................... 44 APPENDIX D: STATIC AND DYNAMIC REPLICATION OF A VOLATILITY SWAP .................................................. 48 REFERENCES .......................................................................................... 50

0

Goldman Sachs

QUANTITATIVE STRATEGIES RESEARCH NOTES

INTRODUCTION

A stock’s volatility is the simplest measure of its riskiness or uncertainty. Formally, the volatility σR is the annualized standard deviation of the stock’s returns during the period of interest, where the subscript R denotes the observed or “realized” volatility. This note is concerned with volatility swaps and other instruments suitable for trading volatility1. Why trade volatility? Just as stock investors think they know something about the direction of the stock market, or bond investors think they can foresee the probable direction of interest rates, so you may think you have insight into the level of future volatility. If you think current volatility is low, for the right price you might want to take a position that proﬁts if volatility increases. Investors who want to obtain pure exposure to the direction of a stock price can buy or sell short the stock. What do you do if you simply want exposure to a stock’s volatility? Stock options are impure: they provide exposure to both the direction of the stock price and its volatility. If you hedge the options according to Black-Scholes prescription, you can remove the exposure to the stock price. But delta-hedging is at best inaccurate because the real world violates many of the Black-Scholes assumptions: volatility cannot be accurately estimated, stocks cannot be traded continuously, transactions costs cannot be ignored, markets sometimes move discontinuously and liquidity is often a problem. Nevertheless, imperfect as they are, until recently options were the only volatility vehicle available.

Volatility Swaps

The easy way to trade volatility is to use volatility swaps, sometimes called realized volatility forward contracts, because they provide pure exposure to volatility (and only to volatility). A stock volatility swap is a forward contract on annualized volatility. Its payoff at expiration is equal to ( σ R – K vol ) × N

(EQ 1)

where σR is the realized stock volatility (quoted in annual terms) over the life of the contract, Kvol is the annualized volatility delivery price, and N is the notional amount of the swap in dollars per annualized volatility point. The holder of a volatility swap at expiration receives N dollars for every point by which the stock’s realized volatility σR has

1. For a discussion of volatility as an asset class, see Derman, Kamal, Kani, McClure, Pirasteh, and Zou (1996).

1

using daily closing prices of the S&P 500 index. As with all forward contracts or swaps. low ones will likely rise. if you foresee a rapid decline in political and ﬁnancial turmoil after a forthcoming election. The procedure for calculating the realized volatility should be clearly speciﬁed with respect to the following aspects: • The source and observation frequency of stock or index prices – for example. volatilities appear to revert to the mean. N = $250.000/(volatility point). Therefore. As with interest rates. the difference is usually negligible. Directional Trading of Volatility Levels. • The annualization factor in moving from daily or hourly observations to annualized volatilities – for example. for example 30%. This provides a much more direct method than trading and hedging options. the fair delivery price Kvol of a volatility swap is a value close to the level of current implied volatilities for options with the same expiration as the swap. a short position in volatility might be appropriate. The delivery price Kvol is typically quoted as a volatility. and tends to stay high after large downward moves in the market. volatility is often negatively correlated with stock or index level. The zero mean method is theoretically preferable. Who Can Use Volatility Swaps? Volatility has several characteristics that make trading attractive. using 260 business days per year as a multiplicative factor in computing annualized variances from daily returns. the fair value of volatility at any time is the delivery price that makes the swap currently have zero value. As we will show later. Finally. or by assuming a zero mean. several uses for volatility swaps follow.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES exceeded the volatility delivery price Kvol. For example. He or she is swapping a ﬁxed volatility Kvol for the actual (“ﬂoating”) future volatility σR. The notional amount is typically quoted in dollars per volatility point. Trading the Spread between Realized and Implied Volatility Levels. and • Whether the standard deviation of returns is calculated by subtracting the sample mean from each return. Clients who want to speculate on the future levels of stock or index volatility can go long or short realized volatility with a swap. high volatilities will eventually decrease. Given these tendencies. It is likely to grow when uncertainty and risk increase. For frequently observed prices. by unwinding 2 . because it corresponds most closely to the contract that can be replicated by options portfolios. for example.

Variance Swaps Although options market participants talk of volatility. it is variance. Its payoff at expiration is equal to ( σ R – K var ) × N 2 2 (EQ 2) where σ R is the realized stock variance (quoted in annual terms) over the life of the contract. If overall market volatility increases. and the swap that can be replicated most reliably (by portfolios of options of varying strikes.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES the swap before expiration. a long volatility hedge may be appropriate. the merger may become less likely and the spread may widen. Hedging Implicit Volatility Exposure. that has more fundamental theoretical signiﬁcance. as we show later) is a variance swap. and N is the notional amount of the swap in dollars per annualized volatility point squared. you can trade the spread between realized and implied volatility. • Portfolio managers who are judged against a benchmark have tracking error that may increase in periods of higher volatility. • Investors following active benchmarking strategies may require more frequent rebalancing and greater transactions expenses during volatile periods. diversiﬁcation across countries has become a less effective portfolio hedge. Kvar is the delivery price for variance. • Equity funds are probably short volatility because of the negative correlation between index level and volatility. The holder of a variance swap at expiration receives N dollars for every point by which the stock’s realized variance σ R has exceeded the variance delivery price Kvar. This is so because the correct way to value a swap is to value the portfolio that replicates it. 2 3 . especially for ﬁnancial businesses. the square of the realized volatility. There nesses that are implicitly short volatility: are several busi- • Risk arbitrageurs or hedge funds often take positions which assume that the spread between stocks of companies planning mergers will narrow. or volatility squared. A variance swap is a forward contract on annualized variance. As global equity correlations have increased. Since volatility is one of the few parameters that tends to increase during global equity declines.

this presentation is capable of much greater generalization. The fair value of variance is the delivery price that makes the swap have zero value. The formulas and the intuition they provide are beneﬁcial in rapidly estimating the effect of changes in the skew on swap values. we will return to a discussion of the additional risks involved in replicating and valuing volatility swaps. we explain how this exotic option itself can be replicated by a portfolio of standard stock options with a range of strikes. provides a payoff equal to the variance of the stock’s returns under a fairly wide set of circumstances. Outline Most of this note will focus on the theory and properties of variance swaps. Some practical issues concerning the choice of strikes are also discussed. how the apparently complex hedged log contract produces an instrument with the simple constant exposure to the realized variance of a variance swap. The delivery price Kvar can be quoted as a volatility squared. for example.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Though theoretically simpler. and so their quoting conventions vary. Then. First. 4 . so that their market prices determine the cost of the variance swap. we show that the hedging of a (slightly) exotic stock option. without detailed numerical computation. the notional amount can be expressed as $100. We also provide insight into the swap by showing. In particular. especially for index options. Black-Scholes-based account of the fundamental strategy by which a variance swap can be replicated and valued. Therefore. we derive theoretical formulas that allow us to simply determine the approximate effect of the skew on the fair value of index variance swaps. Similarly. without depending on the full validity of the Black-Scholes model.000/(one volatility point)2. for a skew linear in strike or linear in delta. In Section III. variance swaps are less commonly traded. variance can serve as the basic building block for constructing other volatility-dependent instruments. At the end. from a variety of viewpoints. we devote Section IV to the effects of the skew. for example (30%)2. This cost. Though more difﬁcult. Section II derives the same results much more rigorously and generally. The fair value of the variance swap is determined by the cost of the replicating portfolio of options. is signiﬁcantly affected by the volatility smile or skew. which provide similar volatility exposure to straight volatility swaps. the log contract. Because of its fundamental role. we provide a detailed numerical example of the valuation of a variance swap. Section I presents an intuitive.

It also shows how the replication can be approximated in practice when only a discrete set of strikes are available. and stock prices can jump.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES The fair value of a variance swap is based on (1) the ability to replicate a log contract by means of a portfolio of options with a (continuous) range of strikes. In Appendix B. Since variance can be replicated relatively simply. it is useful to regard volatility as the square root of variance. Section V discusses the effects of these real limitations on pricing. and (2) on classical options valuation theory. a volatility swap can be dynamically hedged by trading the underlying variance swap. Appendix D provides additional insight into the static and dynamic hedging of a volatility swap using the variance as an underlyer. Section VI explains the risks involved in replicating a volatility contract. and its value depends on the volatility of the underlying variance – that is. we derive the approximate formulas for the value of an index variance contract in the presence of a volatility skew that varies linearly with strike. Finally. In practice. which assumes continuous stock price evolution. Thus. In Appendix C. not all strikes are available. Four appendices cover some more advanced mathematics. on the volatility of volatility. 5 . From this point of view. we derive the details of the replication of a log contract by means of a continuum of option strikes. we derive the analogous formulas for a skew varying linearly with the delta exposure of the options. volatility is itself a square-root derivative contract on variance. In Appendix A.

What you want is a portfo2 2 2 2. σ τ ) . (We have written the option value as a function of σ τ in order to make clear that all its dependence on both volatility and time to expiration is expressed in the combined variable σ τ . without jumps. and v = σ τ is the total variance of the stock to expiration. because. in the Black-Scholes formula with zero interest rate. 100 and 120. We ease the development of intuition by assuming here that the riskless interest rate is zero. In the next section. where 2σ 2π 2 log ( S ⁄ K ) + ( σ τ ) ⁄ 2 d 1 = ----------------------------------------------------. 6 . your sensitivity to further changes in variance is altered.) We will call the exposure of an option to a stock’s variance V . it measures the change in value of the position resulting from a change in variance2. we explain the replicating strategy that captures realized variance. The cost of implementing that strategy is the fair value of future realized variance. V is closely related to the time sensitivity or time decay of the option.. Suppose at time t you own a standard call option of strike K and expiration T. as long as the stock price evolves continuously – that is. Note that d1 depends only on the two combinations S/K and σ τ . we deﬁne the sensitivity V = 2 ∂C BS ∂σ 2 S τ exp ( – d 1 ⁄ 2 ) = ---------. We approach variance replication by building on the reader’s assumed familiarity with the standard Black-Scholes model. options values depend on the total variance σ τ . for each of three different options with strikes 80. we shall provide a more general proof that you can replicate variance. σ is the stock’s variance. where S is the current stock price. a single option is an imperfect vehicle: as soon as the stock price moves. the variance exposure V is largest when the option is at the money.. Figure 1a shows a graph of how V varies with stock price S. even when some of the Black-Scholes assumptions fail.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES REPLICATING VARIANCE SWAPS: FIRST STEPS The Intuitive Approach: Creating a Portfolio of Options Whose Variance Sensitivity is Independent of Stock Price In this section. For each strike. We will sometimes refer to V as “variance σ τ vega”. σ is the return volatility of the stock. If you want a long position in future realized variance. τ is the time to expiration (T − t). Here. K . V decreases extremely rapidly as S leaves the vicinity of the strike K. whose value is given by the BlackScholes formula C BS ( S. and falls off rapidly as the stock price moves in or out of the money.------------------------------.

This follows from the formula in footnote 2. each panel having the options more closely spaced. weighted in inverse proportion to the square of the strike level. Figures 1c. and you can observe it in the increasing height of the V -peaks in Figure 1a. the contributions of all options overlap at any deﬁnite S. To obtain a portfolio that responds to volatility or variance independent of moves in the stock price. Because out-of2 2 2 2 7 . with weights inversely proportional to K . What combination of strikes will give you such undiluted variance exposure? Figure 1b shows the variance exposure for the portfolio consisting of all three option strikes in Figure 1a. and provided the strikes are distributed evenly and closely. You can also understand this intuitively. to offset this accumulation of S-dependence. you need to combine options of many strikes. and how does trading it capture variance? Consider the portfolio Π ( S. The dotted line represents the sum of equally weighted strikes. as long as S lies inside the range of available strikes and far from the edge of the range. each additional option of higher strike in the portfolio will provide an additional contribution to V proportional to that strike. the portfolio with weights inversely proportional to K produces a V that is virtually independent of stock price S. If you own a portfolio of options of all strikes. e and g show the individual sensitivities to variance of increasing numbers of options. Clearly. As the stock price moves up to higher values. σ τ ) of options of all strikes K and a single expiration τ. In addition. Figures 1d. weighted inversely proportional to K . What does this portfolio of options look like. just what is needed to trade variance. you will obtain an exposure to variance that is independent of stock price. one needs diminishing amounts of higher-strike options. f and h show the sensitivity for the equally-weighted and strike-weighted portfolios. An option with higher strike will therefore produce a V contribution that increases with S.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES lio whose sensitivity to realized variance is independent of the stock price S. Therefore. Appendix A provides a mathematical derivation of the requirement that options be weighted inversely proportional to K in order to achieve constant V. the solid line represents the sum with weights in inverse proportion to the square of their strike.

120 equally weighted weighted inversely proportional to square of strike (a) (b) 20 60 100 140 180 20 60 100 140 180 strikes 60 to 140 spaced 20 apart (c) (d) 20 60 100 140 180 20 60 100 140 180 strikes 60 to 140 spaced 10 apart (e) (f) 20 60 100 140 180 20 60 100 140 180 strikes 20 to 180 spaced 1 apart (g) (h) 20 60 100 140 180 20 60 100 140 180 8 . the solid line corresponds to weights inversely proportional to K2. The variance exposure. The corresponding ﬁgure on the right shows the sum of the contributions. weighted two different ways. V.100.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FIGURE 1. of portfolios of call options of different strikes as a function of stock price S. Each ﬁgure on the left shows the individual V i contributions for each option of strike Ki. and becomes totally independent of stock price S inside the strike range strikes: 80. the dotted line corresponds to an equally-weighted sum of options.

P ( S. K . Note how little the value of the portfolio before expiration differs from its value at expiration at the same stock price. K . At expiration. From now on. σ τ ) for strikes varying continuously from S* to inﬁnity3. and call options C ( S. the variance exposure of Π is τ V = -2 (EQ 5) 2 To obtain an initial exposure of $1 per volatility point squared. when t = T. we will use Π to refer to the value of this new portfolio. at time t you can sum all the Black-Scholes options values to show that the total portfolio value is 2 S – S* S σ τ Π ( S. and ST is the terminal stock price. σ τ ) = 1 1 -------C ( S.– log ----. K . σ τ ) + ------. Similarly. one can show that the sum of all the payoff values of the options in the portfolio is simply ST – S* S T Π ( S T .– log ------- S* S* (EQ 3) where log( ) denotes the natural logarithm function. σ τ ) for strikes K varying continuously from zero up to some reference price S*. namely 3. we employ put options P ( S. σ τ ) = --------------. The only difference is the additional value due to half the total variance σ τ . σ τ ) ∑ K2 2 K K > S* K < S* ∑ 9 . Clearly. you need to hold (2/T) units of the portfolio Π. 0 ) = ------------------.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES the-money options are generally more liquid. + ------- S * S* 2 (EQ 4) where S is the stock price at time t. You can think of S* as the approximate at-the-money forward stock level that marks the boundary between liquid puts and liquid calls. K . Formally. the expression for the portfolio is given by Π ( S.

The second term. 10 . All of the volatility sensitivity of the weighted portfolio of options we have created is contained in the log contract. (a) Individual contributions to the payoff from put options with all integer strikes from 20 to 99. It is not really an option.– log ------S* S* Π ( ST.– log ----. – log ( S ⁄ S * ) . and whose correct hedging depends on the volatility of the stock.--------------. weighted payoffs of puts and calls and (2) a long position in a forward contract and a short position in a log contract. and (2) the payoff of a long position in a forward contract and a short position in a log contract. (S − S*)/S*. with weight inversely proportional to the square of the strike.σ S * T T S* (EQ 6) The ﬁrst term in the payoff in Equation 6. once and for all. See also Neuberger (1996). and call options with all integer strikes from 100 to 180. 0 ) 20 60 100 140 180 20 60 100 140 180 (a) (b) 4.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES τ 2 2 S – S* S Π ( S. ST ST – S* ------------------. + --. (b) The payoff of 1/100 of a long position in a forward contract with delivery price 100 and one short position in a log contract with reference value 100. without any knowledge of the stock’s volatility. The log contract was ﬁrst discussed in Neuberger (1994). Figure 2 graphically illustrates the equivalence between (1) the summed. its value represents a long position in the stock (value S) and a short position in a bond (value S*). a so-called exotic option whose payoff is proportional to the log of the stock at expiration. FIGURE 2. An example that illustrates the equivalence at expiration between (1) Π(ST. which can be statically replicated. σ τ ) = --.0) the weighted sum of puts and calls. describes a short position in a log contract4 with reference value S*. describes 1/S* forward contracts on the stock with delivery price S*.

--------------. T ) = – --. you will see that by rehedging the position in log contracts.-----------------. will be payoff = ( σ R – σ I ) 2 2 (EQ 7) Looking back at Equation 2.– log ------ + σ R T S* S * The net payoff on the position. σ. the initial fair value of the position captured by delta-hedging would have been S 0 2 2 S0 – S* Π 0 = --. the portfolio of options whose variance vega is independent of the stock price S can be written (T – t) 2 2 S – S* S Π ( S. assume that we are in a Black-Scholes world where the implied volatility σ I is the estimate of future realized volatility.– log ------ + σ I T S* S * At expiration.σ S * T T S* The ( S – S * ) term represents a long position in the stock and a short position in a bond. been the owner of a position in a variance swap with fair strike Kvar = σ I and face value $1. in a Black-Scholes world with zero interest rates and zero dividend yield. Gamma and Theta of a Log Contract 2 In Equation 6 we showed that. both of which can be statically hedged with no dependence on volatility. let us concentrate on the log contract term alone.log ----. The Vega. + ---------------. you have. In contrast. If you take a position in the portfolio Π.– log ----. σ. hedged to expiration.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Trading Realized Volatility with a Log Contract For now. whose value at time t for a logarithmic payoff at time T is (T – t) 2 2 S L ( S. the fair value you should pay at time t = 0 when the stock price is S0 is S 0 2 2 S0 – S* Π 0 = --. the log( ) term needs continual dynamic rehedging. + ---------------.-----------------. T ) = --. in effect. You will have proﬁted (or lost) if realized volatility has exceeded (or been exceeded by) implied volatility. t. if the realized volatility turns out to have been σ R .σ S * T T (EQ 8) 11 . t. Therefore.

The log contract’s gamma. is a smoother function of S than the sharply peaked gamma of a single option. The time decay of the log contract. That is. and decreases linearly to zero as the contract approaches expiration.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES The sensitivities of the value of this portfolio are precisely appropriate for trading variance. The log contract’s exposure to stock price is 21 . all the initial variance has been lost.Γ = --. the rate at which the exposure changes as the stock price moves. as we now show. The gamma of the portfolio.∆ = – --.σ T (EQ 10) The contract loses time value at a constant rate proportional to its variance. It states that the disadvantage of negative theta (the decrease in value with time to expiration) is offset by the beneﬁt of positive gamma (the curvature of the payoff).-----T S2 (EQ 11) Gamma is a measure of the risk of hedging an option. The variance vega of the portfolio in Equation 8 is T–t V = ----------. since each share of stock is worth S. you need a constant long position in $(2/T) worth of stock to be hedged at any time. is 1 2 θ = – --. so that at expiration. 12 . is 2 1 .ΓS 2 σ = 0 2 (EQ 12) Equation 12 is the essence of the Black-Scholes options pricing theory. T (EQ 9) The exposure to variance is equal to 1 at t = 0. Equations 10 and 11 can be combined to show that 2 1 θ + -.--TS shares of stock. being the sum of the gammas of a portfolio of puts and calls. the rate at which its value changes if the stock price remains unchanged as time passes.

continuous hedging of a log contract produces a payoff whose value is proportional to future realized variance. Here the variance vega is independent of stock price level. spaced $10 apart. it is difﬁcult to extend these argument clearly. and the deviation is greater at earlier times. the coarser spacing causes the vega surface to develop corrugations between strike values that grow more pronounced closer to expiration. Figure 3 shows how the variance vega of a three-month variance swap is affected by imperfect replication. The somewhat intuitive derivations in this section have assumed that interest rates and dividend yields are zero. trading the imperfectly replicated log contract will allow variance to accrue at the correct rate. In practice. this isn’t possible. even when the stock and options market satisfy all the Black-Scholes assumptions: there are only a ﬁnite number of options available at any maturity. Now. although the range of strikes is greater. Here. and decreases linearly with time to expiration. as expected for a swap whose value is proportional to the remaining variance σ τ at any time. but it is not hard to generalize them. and the correct answers when they do not hold. appropriately weighted. In practice. but the conditions under which they hold. In this section. Figure 3b shows strikes from $75 to $125. Figure 3a shows the ideal variance vega that results from a portfolio of puts and calls of all strikes from zero to inﬁnity. Whenever the stock price moves outside. deviation from constant variance vega develops at the tail of the strike range. we move on to a more general and rigorous derivation of the value of variance swaps based on replication. We have also shown that you can use a portfolio of appropriately weighted puts and calls to approximate a log contract. in the presence of an implied volatility skew. Figure 3c shows the vega for strikes from $20 to $200. Finally. the reduced vega of the imperfectly replicated log contract will make it less responsive than a true variance swap. Many of the results will be similar. weighted in inverse proportion to the strike squared. we have shown that the dynamic.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Imperfect Hedges It takes an inﬁnite number of strikes. uniformly spaced $1 apart. will be more easily understandable. 2 The Limitations of the Intuitive Approach A variance swap has a payoff proportional to realized variance. Therefore. Figure 1 illustrates that a ﬁnite number of strikes fails to produce a uniform V as the stock price moves outside the range of the available strikes. to replicate a variance swap. We have also assumed that all the Black-Scholes assumptions hold. 13 . As long as the stock price remains within the strike range. assuming the Black-Scholes world for stock and options markets.

of a portfolio of puts and calls.1 0 60 14 .1 0 60 (c) V v 140 120 100 0. V (a) v 120 100 0.1 0 60 (b) V v 120 100 0. and chosen to replicate a three-month variance swap. The variance vega. (a) An inﬁnite number of strikes.2 80 140 S τ 0.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FIGURE 3.2 80 140 S τ 0. V . (c) Strikes from $20 to $200. uniformly spaced $10 apart. (b) Strikes from $75 to $125.2 80 S τ 0. weighted inversely proportional to the square of the strike level. uniformly spaced $1 apart.

For simplicity of presentation. the result – that the dynamic hedging of a log contract captures realized volatility – holds true more generally. The theoretical deﬁnition of realized variance for a given price history is the continuous integral 1 T V = --. … ) dt T 0 ∫ (EQ 14) This is a good approximation to the variance of daily returns used in the contract terms of most variance swaps.= µ ( t.. The value of a forward contract F on future realized variance with strike K is the expected present value of the future payoff in the risk-neutral world: F = E [ e – rT ( V – K ) ] (EQ 15) Here r is the risk-free discount rate corresponding to the expiration date T. (In a later section. The fair delivery value of future realized variance is the strike K var for which the contract has zero present value: K var = E [ V ] (EQ 16) 15 . and E[ ] denotes the expectation.. or continuous – this means that no jumps are allowed. t ) of stock price and time only. we assume the stock pays no dividends. . we assume that the drift µ and the continuously-sampled volatility σ are arbitrary functions of time and other parameters. we assume that the stock price evolution is given by dS t --------. allowing for dividends does not signiﬁcantly alter the derivation. )dt + σ ( t. . These assumptions include.σ 2 ( t. Conceptually. implied tree models in which the volatility is a function σ ( S.) Therefore. but are not restricted to.. we explained how to replicate a variance swap by means of a portfolio of options whose payoffs approximate a log contract. valuing a variance forward contract or “swap” is no different than valuing any other derivative security.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES REPLICATING VARIANCE SWAPS: GENERAL RESULTS In the previous section. Although our explanation depended on the validity of the BlackScholes model. The only assumption we will make about the future underlyer evolution is that it is diffusive. we will consider the effects of discontinuous stock price movements on the success of the replication. )dZ t St (EQ 13) Here..

See. Summing Equation 19 over all times from 0 to T. the so-called local volatility σ ( S. t ) consistent with all current options prices is extracted from the market prices of traded stock options.– d ( log S t ) = -. The above approach is good for valuing the contract. By applying Ito’s lemma to log S t . we ﬁnd 1 d ( log S t ) = µ – -.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES If the future volatility in Equation 13 is speciﬁed. You can then use simulation to calculate the fair variance Kvar as the average of the experienced variance along each simulated path consistent with the risk-neutral stock price evolution given of Equation 13. Derman and Kani (1994). we obtain dS t 1 2 --------. Kani and Zou (1996). In implied tree models5. This approach was ﬁrst outlined in Derman.σ dt 2 St (EQ 19) (EQ 18) in which all dependence on the drift µ has cancelled. generates a payoff proportional to the incremental variance of the stock during that time6. The essence of the replication strategy is to devise a position that. then one approach for calculating the fair price of variance is to directly calculate the riskneutral expectation T 1 K var = --. where the drift µ is set equal to the riskless rate. Kamal. but it does not provide insight into how to replicate it. see Carr and Madan (1998). … ) dt T 0 ∫ (EQ 17) No one knows with certainty the value of future volatility. 6. for example. 16 . and Zou (1996).E σ 2 ( t. over the next instant of time. we obtain the continuously-sampled variance 5. Kani.σ 2 dt + σdZ t 2 Subtracting Equation 18 from Equation 13. For an alternative discussion. Dupire (1994) and Derman.

has a forward price that grows at the riskless rate. In a risk-neutral world with a constant risk-free rate r. pays the logarithm of the total return. 17 .σ dt T ∫ 0 (EQ 20) ST 2 = ---------. so that ST T dS t 2 K var = --.– log ------T S0 0 St ∫ (EQ 21) The expected value of the ﬁrst term in Equation 21 accounts for the cost of rebalancing. the underlyer evolves according to: dS t -------. as long as it moves continuously.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES T 1 2 V ≡ --. as in Equation 17. continuously rebalanced to be worth $1. … )dZ St (EQ 22) so that the risk-neutral price of the rebalancing component of the hedging strategy is given by E ∫0 --------St T dS t = rT (EQ 23) This equation represents the fact that a shares position.– log ------T 0 St S0 ∫ T dS t This mathematical identity dictates the replication strategy for variance.= rdt + σ ( t. Valuing and Pricing the Variance Swap Equation 20 provides another method for calculating the fair variance. at expiration.E -------. The ﬁrst term in the brackets can be thought of as the net outcome of continuous rebalancing a stock position so that it is always instantaneously long 1/S t shares of stock worth $1. Instead of averaging over future variances. Following this continuous rebalancing strategy captures the realized variance of the stock from inception to expiration at time T. Note that no expectations or averages have been taken – Equation 20 guarantees that variance can be captured no matter which path the stock price takes. one can take the expected risk-neutral value of the right-hand side of Equation 20 to obtain the cost of replication directly. The second term represents a static short position in a contract which.

+ log -----S0 S* S0 (EQ 24) The second term log ( S * ⁄ S 0 ) is constant. 0 ) d K K2 1 ∫S -------. one must duplicate the log payoff. The log payoff can then be rewritten as ST ST S* log ------. can be duplicated using standard options with all possible strike levels and the same expiration time T. We introduce a new arbitrary parameter S* to deﬁne the boundary between calls and puts. for all strikes from 0 to S*.Max ( K – S T . • a long position in ( 1 ⁄ K 2 ) put options struck at K. 0 ) dK K2 * Equation 25 represents the decomposition of a log payoff into a portfolio consisting of: • a short position in ( 1 ⁄ S * ) forward contracts struck at S*. the remaining curved component. For practical reasons we want to duplicate the log payoff with liquid options – that is.Max ( ST – K .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES As there are no actively traded log contracts for the second term in Equation 21. Figure 4 shows this decomposition schematically. independent of the ﬁnal stock price ST. All contracts expire at time T. which holds for all future values of ST. and then duplicating each of these separately. for all strikes from S* to ∞ .= – ------------------S* S* + + (forward contract) (put options) (call options) (EQ 25) ∫0 S* ∞ 1 ------. The following mathematical identity. representing the quadratic and higher order contributions. suggests the decomposition of the log-payoff: ST – S* ST – log ------. and • a similar long position in ( 1 ⁄ K 2 ) call options struck at K. 18 .= log ------. by decomposing its shape into linear and curved components. The linear component can be duplicated with a forward contract on the stock with delivery time T. at all stock price levels at expiration. so only the ﬁrst term has to be replicated. with a combination of out-of-the-money calls for high stock values and out-of-the-money puts for low stock values.

(b) Dashed line: the linear payoff at expiration of a forward contract with delivery price S*.e – 1 – log -----T S0 S* + e rT + e rT ∫0 ∞ S* 1 ------. we obtain S* S 0 rT 2 K var = --. you obtain an estimate of the current market price of future variance. It provides a direct connection between the market cost of options and the strategy for capturing future realized volatility. and makes less assumptions than our intuitive treatment in the section on page 6. This approach to the fair value of future variance is the most rigorous from a theoretical point of view. If you use the market prices of these options. FIGURE 4. Equation 26 makes precise the intuitive notion that implied volatilities can be regarded as the market’s expectation of future realized volatilities. By using the identities in Equations 23 and 25. rT – -----. respectively. Each option is weighted by the inverse square of its strike. denote the current fair value of a put and call option of strike K. ST – log ------S* portfolio of options ST – S* – ------------------S* S* S* (a) (b) 19 . even when there is an implied volatility skew and the simple Black-Scholes formula is invalid. Replication of the log payoff. (a) The payoff of a short position in a log contract at expiration.C ( K ) dK K2 * where P(K) and (C(K)).Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES The fair value of future variance can be related to the initial fair value of each term on the right hand side of Equation 21. The sum of the payoffs for the dashed and solid lines provide the same payoff as the log contract.P ( K ) d K K2 1 (EQ 26) ∫S -------. Solid line: the curved payoff of calls struck above S* and puts struck below S* .

+ e rT Π CP T S0 S* (EQ 27) where Π CP is the present value of the portfolio of options with payoff at expiration given by S T 2 ST – S* f ( S T ) = --.– log ------- T S* S* (EQ 28) Suppose that you can trade call options with strikes Kic such that K 0 = S * < K 1c < K 2c < K 3c < . Π CP is obtained from Π CP = ∑ w ( K ip )P ( S. and put options with strikes Kip such that K 0 = S * > K 1 p > K 2 p > K 3 p > .+ ------------------... say S* = S0. K ic ) i i (EQ 29) We now illustrate this procedure with a concrete numerical example.E -------. ------------------. but never be worth less.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES AN EXAMPLE OF A VARIANCE SWAP We now present a detailed practical example.rT – -----. which can be written as ST S* ST – S* T dS t S T – S * 2 K var ≡ --. only a small set of discrete option strikes is available.– log -----. however.. If you could buy options of all strikes between zero and inﬁnity. Once these weights are calculated. and using Equation 26 with only a few strikes leads to appreciable errors. In practice.e – 1 – log -----. Suppose you want to price a swap on the realized variance of the daily returns of some hypothetical equity index.– log ------T S* S* S* S0 0 St ∫ Taking expectations. Here we suggest a better approximation. the fair variance would be given by Equation 26 with some choice of S*. K ip ) + ∑ w ( K ic )C ( S. In Appendix A we derive the formula that determines how many options of each strike you need in order to approximate the payoff f(ST) by piece-wise linear options payoffs. 20 .– ------------------. The procedure in Appendix A guarantees that these payoffs will always exceed or match the value of the log contract. The fair delivery variance is determined by the cost of the replicating strategy discussed in the previous section. this becomes S* S 0 rT 2 K var = --. We start with the deﬁnition of fair variance given by Equation 21..

8691 83.8874 0.9130 1.0013 0.2578 0.83 33.55 30.0057 0.3616 70. the continuously compounded annual riskless interest rate r is 5%.0002 0.15 45.27 82.0958 0.25. and the maturity of the variance swap is three months (T = 0.1289 0.0001 419.0003 0.0829 16.04 134.3615 89.26 63.9939 6.00 20.0075 0.0276 0.1476 0.2854 0.5560 1.6747 3.98 72.000006 TOTAL COST 0.0260 75.27 0.7384 1.02 22.000002 0.5790 2. the dividend yield is zero.98 19.63 113.0241 0.0067 0.69 28.0459 37. Suppose that 21 .19 25.4119 0.49 56.0501 0.63 36. Strike Volatility Weight Value per Option Contribution 50 55 60 65 70 PUTS 75 80 85 90 95 100 100 105 110 CALLS 115 120 125 130 135 30 29 28 27 26 25 24 23 22 21 20 20 19 18 17 16 15 14 13 163.23 50.00003 0.2581 0.3537 4.0004 0.8671 Assume that the index level S0 is 100. The portfolio of European-style put and call options used for calculating the cost of capturing realized variance in the presence of the implied volatility skew with a discrete set of options strikes.7752 7.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES TABLE 1.05 96.98 24.1580 29.0035 0.

We assume that at-the-money implied volatility is 20%. for two cases. The theoretical fair variance for ∆K = 0 is then (20)2 = 400. In Table 1 we provide the list of strikes and their corresponding implied volatilities. with a skew such that the implied volatility increases by 1 volatility point for every 5 point decrease in the strike level. The line with square symbols shows the convergence for no skew. At the bottom of the table we show the total cost of the options portfolio. It is clear from Table 1 that most of the cost comes from options with strikes near the spot value. Π CP = 419. the spacing between strikes. uniformly spaced 5 points apart. towards the fair value of variance as a function of ∆K. This is not strictly the fair variance. The cost of capturing variance is now simply calculated using Equation 27 with the result K var = ( 20. We then show the weights. this value is higher than the true theoretical value for the fair variance obtained by approximating the log contract with a continuum of strikes. the cost of capturing variance with a discrete set of strikes.8671 . the extra contribution coming from the effect of the skew. the value of each individual option and the contribution of each strike level to the total cost of the portfolio. because the procedure of approximating the log contract in Appendix A always over-estimates the value of the log contract. their value is small and contributes little to the total cost. 2 420 415 K var 410 405 400 0 1 2 DK 3 4 5 22 . Although the number of options which are far out of the money is large. The line with diamond symbols shows similar convergence to a higher fair variance of about 402. the cost of capturing variance approaches the theoretically fair variance. Convergence of Kvar. with and without a volatility skew. In Figure 5 we illustrate the cost of variance as function of the spacing between strikes.467 ) . FIGURE 5. with all implied volatilities at the same value of 20%. You can see that as the spacing between strikes approaches zero.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES you can buy options with strikes in the range from 50 to 150.

is 2 volatility points higher than Σ0. We assume that there is no term structure and consider two different skew parameterizations. (Note that b in Equation 30 has the same dimension as volatility. computed from Equation 26.. Note that this parametrization cannot hold for all strikes. 7. the second a skew that varies linearly with the Black-Scholes delta. with a positive value indicating a higher volatility for strikes below the forward. ) 2 (EQ 31) The skew increases the value of the fair variance above the at-themoney-forward level of volatility. This approximation works best for short maturities and skews that are not too steep. This formula provides a good rule of thumb for a quick estimate of the impact of the volatility skew on the fair variance. both of which resemble typical index skews. for a large enough value of K. Here we discuss the effects of a volatility skew on the fair variance. the options prices in Equation 26 are negligible and therefore do not affect the value of the fair variance. so that K – SF Σ ( K ) = Σ 0 – b -----------------S F (EQ 30) Skew Linear in Strike Here Σ0 is the implied volatility of an option struck at the forward. for example. In Appendix B we derive the following approximate formula for the fair variance of the contract with time to expiration T: K var ≈ Σ 0 ( 1 + 3Tb 2 + . and the size of the increase is proportional to time to maturity and the square of the skew slope. Note that for large values of K.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES EFFECTS OF THE VOLATILITY SKEW The general strategy discussed in the previous section can be used to determine the fair variance and the hedging portfolio from the set of available options and their implied volatilities. The steepness of the skew is determined by the slope b. Note also that there is no term b T in Equation 31. The ﬁrst is a skew that varies linearly with the strike of the option. In both cases we will compare the numerically correct value of fair variance. because. A value of b = 0.. where this parameterization is invalid. We ﬁrst consider a skew for which the implied volatility varies linearly with strike.2 means that the implied volatility corresponding to a strike 10% below the forward. with an approximate analytic formula that we derive. so that b2T is a dimensionless parameter. and therefore a natural candidate for the order of magnitude of the percentage correction to Kvar.. 23 . the implied volatility would become negative7.

as a function of the skew slope b.3 Kvar 1050 1050 1000 950 900 0. with the approximate values given by the analytic formula in Equation 31.0 0. Comparison of the exact fair variance. The thin line with squares shows the exact values obtained by replicating the log-payoff. Comparison of the exact value of fair variance. We assume Σ0 = 30%. (b) one-year variance swap.81 ) 2 2 2 2 Figure 6 contains a graph of these results.01 ) ( 30. (a) three-month variance swap. The thick line depicts the approximate value given by Equation 31.11 ) ( 30.00 ) ( 30. the continuously compounded annual discount rate r = 5%. We see excellent agreement in the case of the three-month variance swap.44 ) ( 30.2 0. and reasonable agreement for one year. Kvar.1 0. with the approximate analytic formula of Equation 31.3 ( 30.00 ) ( 30.65 ) ( 30.1 0. T = 3 months Skew Slope b Exact Value Analytic Approximation 2 2 2 2 T = 1 year Exact Value Analytic Approximation 2 2 2 2 0. S = 100.05 ) ( 30. computed numerically.97 ) ( 30.75 ) ( 33.2 0. and use strikes evenly spaced one point apart from K = 10 to K = 200 to replicate the log payoff. FIGURE 6. with the approximate value from the formula of Equation 31.45 ) ( 31. computed numerically.22 ) ( 30.33 ) ( 30.82 ) ( 32.99 ) 2 2 2 2 ( 29.01 ) ( 30. zero dividend yield.1 0.3 b (a) b (b) 24 . 1150 1100 1150 1100 Kvar 1000 950 900 0.2 0. TABLE 2.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES In Table 2 we compare the exact results for fair variance.

since Equation 32 leads to arbitrage violation before b reaches this limit. the ﬁrst-order correction is of magnitude b T .2. which was absent from Equation 30. the implied volatility is always positive provided b < 2Σ0. the change in the skew per unit delta. FIGURE 7.. (a) A volatility skew that varies linearly in delta. 2 (EQ 32) Here ∆p is the Black-Scholes exposure of a put option. and the skew slope is 0. 12 Σ 2 π 0 (EQ 33) Here. This parameter b is not the same as the b in the previous section.----. this parameterization leads to more realistic skews than those produced by the linear-strike formula.. This restriction is irrelevant. (b) The corresponding skew plotted as a function of strike. Σ 0 is the implied volatility of a “50-delta” put option and b is the slope of the skew – that is..+ .K var ≈ Σ 0 1 + -----. In particular.5 -0. where d1 is deﬁned in Footnote 2. the term to maturity is three months. so that: 1 Σ ( ∆ p ) = Σ 0 + b ∆ p + -. the continuously compounded annual discount rate r is 5%. in contrast to the skew linear in strike.25 0 Σ 30 25 20 60 80 100 120 140 ∆p K (a) (b) 25 . In practice. because of the ∆p term.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Skew Linear in Delta Next we consider a skew that varies linearly with the Black-Scholes delta of the option. Since ∆p is bounded. given by ∆ p = – N ( – d 1 ) .b T + ----.75 -0. there is an implicit dependence on the time to expiration in the formula of Equation 32. because a variation linear in delta about the atthe-money-forward strike is not equivalent to a variation linear in strike. 40 35 40 35 Σ 30 25 20 -1 -0. We have assumed that the stock price S is 100. Appendix C presents a detailed derivation of the following approximate formula for the fair variance of the contract with time to expiration T: 2 2 1 1b .

01 ) ( 30.1 0.3 ( 30. with the approximate analytic formula of Equation 33. 1150 1100 1150 1100 Kvar Kvar 1050 1000 950 900 0. (b) Oneyear variance swap.42 ) ( 34.64 ) ( 30. zero dividend yield.49 ) ( 32.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES First. T = 3 months Skew Slope b Exact Value Analytic Approximation 2 2 2 2 T = 1 year Exact Value Analytic Approximation 2 2 2 2 0. computed numerically.61 ) ( 31. with the approximate value from the formula of Equation 33. we compare the exact results computed according to Appendix A with the approximate values given by Equation 33. We assume Σ0 = 30%.60 ) ( 32. we convert the skew by delta in Equation 32 into a skew by strike. as displayed in Figure 8. The analytic formula works very well for the three-month variance swap. The thin line with squares shows the exact values obtained by replicating the log-payoff.03 ) ( 32.2 0.97 ) ( 31.1 0. The thick line depicts the approximate value given by Equation 33. and use strikes evenly spaced one point apart from K = 10 to K = 200 to replicate the log payoff.00 ) ( 30.62 ) ( 31.2 0.93 ) 2 2 2 2 ( 29. Comparison of the fair variance.06 ) ( 30. S = 100.06 ) ( 32.00 ) ( 31. Comparison of the exact value of fair variance. TABLE 3.1 0. the continuously compounded annual discount rate r = 5%. and truly impressively for the oneyear swap. computed numerically. with the approximate values given by the analytic formula in Equation 33. as displayed in Figure 7.06 ) 2 2 2 2 FIGURE 8.2 0. Kvar.0 0.3 b (a) b (b) 26 .3 1050 1000 950 900 0.40 ) ( 34. as a function of the skew slope b. (a) Three-month variance swap. Again. In Table 3 we compare the results for fair variance.

except that the integrals are replaced by sums over the available option strikes whose weights are chosen according to the procedure of Appendix A). may also corrupt the ideal strategy. ranging from 75% to 125% of the initial spot level. like liquidity. so that all options are valued at the same implied volatility. you may be able to trade only a limited range of options strikes. insufﬁcient to accurately replicate the log payoff. We assume here that implied volatility is 25% per year for all strikes. In both cases the strikes are uniformly spaced. Both of these effects cause the strategy to capture a quantity that is not the true realized variance. though other practical issues. we replicate the payoff with traded standard options in a limited strike range. they will capture less than the true realized variance. the stock price may jump. First. and provided the stock price evolves continuously. one point apart.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES PRACTICAL PROBLEMS WITH REPLICATION We have shown in Equation 20 that a variance swap is theoretically equivalent to a dynamically adjusted. the narrow strike range underestimates the fair variance. and (2) a portfolio with a wide range of strikes. the wide strike range accurately approximates the actual square of the implied volatility. together with a static long position in a portfolio of options and a forward that together replicate the payoff of a log contract. Imperfect Replication Due to Limited Strike Range Variance replication requires a log contract. more dramatically so for longer expirations. Because these strikes fail to duplicate the log contract exactly. constant-dollar exposure to the stock. lower estimate of the fair variance. Since log contracts are not traded in practice. from 50% to 200% of the initial spot level. In Table 4 below we show how the estimated value of fair variance is affected by the range of strikes that make up the replicating portfolio. We will focus on the effects of these two limitations below. For both expirations. Two obvious things can go wrong. The fair variances are estimated from (1) a replicating portfolio with a narrow range of strikes. and so produce an inaccurate. However. Therefore. provided the portfolio of options contains all strikes between zero and inﬁnity in the appropriate weight to match the log payoff. (The fair variance is calculated according to Equation 26. Second. with no volatility skew. 27 . they have lower value than that of a true log contract. We also assume a continuously compounded annual interest rate of 5%. This portfolio strategy captures variance exactly.

the nonlinear part of the log payoff: ST ST – S0 -------------------. or vega) in the options portfolio outside 28 . and the reduction in value is greater for the one-year case. that is. the option portfolio payoff remains linear. If you own a limited number of strikes.9 ) 2 ( 23. you capture less than the full realized variance. when the stock price evolves into regions where the curvature of the portfolio is insufﬁciently large. Beyond this range. that is. we have already discussed one approach to understanding why the narrow strike range fails to capture variance. the estimated variance is lower than the true fair value for both expirations above.0 ) 2 ( 25. In essence. and the strategy then fails to accrue realized variance as the stock price moves. from 75 to 125. and. The effect of strike range on estimated fair variance. A simpler way of understanding why a narrow strike range leads to a lower fair variance is to compare the payoff of the narrow-strike replicating portfolio at expiration to the terminal payoff that the portfolio is attempting to replicate. capturing variance requires owning the full log contract.0 ) 2 ( 24. Consequently. Over a longer time period it is more likely that the stock price will evolve outside the strike range. The narrowstrike option portfolio matches the curved part of the log payoff well at stock price levels between the range of strikes. whatever value it takes.0 ) 2 In the section entitled Replicating Variance Swaps: First Steps on page 6. you need to maintain the curvature of the log contract at the current stock price. still appropriately weighted. always growing less rapidly than the nonlinear part of the log contract.125%) Three-month One-year ( 25. whose duplication demands an inﬁnite range of strikes. The lack of curvature (or gamma.– log ------S0 S0 (EQ 34) Figure 9 displays the mismatch between the two payoffs.200%) Narrow strike range (75% .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES TABLE 4. the vega and gamma of a limited strike range both fall to zero when the index moves outside the strike range. As shown in Figure 3. you pay less than the full value. In order to keep capturing variance. Expiration Wide strike range (50% . even if no jumps occur and the stock always moves continuously.

if the log contract has been approximately replicated by only a ﬁnite range of strikes. a discontinuous stock-price jump causes the variance-capture strategy of Equation 20 to capture an amount not equal to the true realized variance. Because of the additive properties of the logarithm function. which we will hedge by following a discrete version of the variance-capture strategy 2 V = --T i=1 ∑ ------------. First. Second.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FIGURE 9. The Effect of Jumps on a Perfectly Replicated Log Contract When the stock price jumps. for two reasons. we focus only on the second effect and examine the effects of jumps assuming that the log-payoff can be replicated perfectly with options. Rather than continuously rebalance as the stock price moves. the terminal log payoff is equivalent to a daily accumulation of log payoffs: 29 . a large jump may take the stock price into a region in which variance does not accrue at the right rate. Comparison of the terminal payoff of the narrow-strike replicating portfolio (dashed line) and the nonlinear part of the log-payoff (solid line). from now on we will assume that we are short the variance swap. we instead adjust the exposure to (2/T) dollars worth of stock only when a new stock price is recorded for updating the realized variance.– log ------Si – 1 S0 N ∆S i ST (EQ 35) where ∆S i = S i – S i – 1 is the change in stock price between successive observations. For the sake of discussion. the log contract may no longer capture realized volatility. both these effects contribute to the replication error. In this section. In reality. Terminal payoff 50 100 ST 150 200 the narrow strike range is responsible for the inability to capture variance. even with perfect replication.

A jump up corresponds to a value J < 0.1. the right hand side of Equation 39 does reduce to the contribution of this (now small) move to the true realized variance. T Si – 1 S i – 1 2 = --. the total (un-annualized) realized variance for a zero-mean contract is the sum 1 V = --T ∑ 2 2 ∆S i ∆S i 1 1 ∆S 2 -----------. the replication error.[ – J – log ( 1 – J ) ] T (EQ 39) jump In the limit that the jump size J is small enough to be regarded as part of a continuous stock evolution process.– log -----------Si – 1 Si – 1 (EQ 36) Suppose that all but one of the daily price changes are well-behaved – that is. = -------------. from S → S ( 1 – J ) . ------- T T S jump S i – 1 S i – 1 no jumps ∑ (EQ 37) The contribution of the jump to the realized total variance is given by: 1 ∆S 2 J2 --. a jump downwards of 10% corresponds to J = 0. -----------.+ … 2 3 (EQ 41) 30 .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES 2 V = --T ∑ i=1 N ∆S i Si -----------. ------- = -----T S jump T (EQ 38) On the other hand. all changes are diffusive. It is only because J is not small that the variance capture strategy is inaccurate.– log -----------. + --. We characterize the jump by the parameter J .[ – J – log ( 1 – J ) ] – -----T T (EQ 40) To understand this result better. except for a single jump event. the percentage jump downwards. because variance is additive. The contribution of this one jump to the variance is easy to isolate. or the P&L (proﬁt/loss) due to the jump for a short position in a variance swap hedged by a long position in a variance-capture strategy is 2 J2 P&L due to jump = --. the impact of the jump on the quantity captured by our variance replication strategy in Equation 36 is Si 2 ∆S i --. Therefore. it is helpful to expand the log function as a series in J: J2 J3 – log ( 1 – J ) = J + -----.+ -----.

A large move downwards (J > 0) leads to a proﬁt for the (short variance swap)(long variance-capture strategy). then the linear dependence of the net position cancels.002 0 -0.P&L due to jump = -. quadratic and higher-order dependence on the stock price.-----. and has no impact on the hedging mismatch. The leading correction is cubic in the jump size J and has a different sign for upwards or downwards jumps. When you are long an option you are long linear. Figure 10 shows the impact of the jump on the strategy for a range of jump values. Since the leading 31 . Furthermore.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES The leading contribution to the replication error is then 2J3 . he impact of a single jump on the proﬁt or loss of a short position in a variance swap and a long position in the variance replication strategy. while a large move upwards (J < 0) leads to a loss.006 Impact of jump 0. while the position in the variance swap is short only the quadratic dependence. this is precisely why hedged long options positions capture variance. In contrast. FIGURE 10.004 -20 -10 0 10 20 Jump size (downward) There is an analogy between the cancellation of the quadratic jump term in variance replication and the linear jump term in options replication. Now the quadratic term in the net position cancels. cubic and higher-order terms in the stock price. leaving only the quadratic and higher-order dependencies.+ … 3T (EQ 42) The quadratic contribution of the jump is the same for the variance swap as it is for the variance-capture strategy. Because the leading-order term is quadratic. leaving only cubic and higher-order dependencies on the jump size.004 0. If you are also short the option’s delta-hedge. Note that the simple cubic approximation of Equation 42 correctly predicts the sign of the P&L for all values of the jump size.002 -0. the variance replication strategy is long quadratic. as given by Equation 40 as a function of (downward) jump size for T=1 year. large moves in either direction beneﬁt the position. in the case of variance replication considered here. a large move one day. 0. followed by a large move in the opposite direction the next day would tend to offset each other.

large enough to move the stock price outside the range of option strikes. there is still a convexity gain from the jump.2 In practice. the vega and gamma of the replicating portfolio are now too low to accrue sufﬁcient variance.2 −20. both the effects of jumps and the risks of log replication with only a limited strike range cause the strategy to capture a quantity different from the true realized variance of the stock price.9 25.8 −80. In this scenario. The combined effect of both these risks is harder to characterize because they interact with one another in a complicated manner. In contrast.2 0. a large move upwards will be doubly damaging: there will be convexity loss due to the jump and the hedge will not capture variance if the jump takes the index outside the strike range.5 −3.8 −6. after this jump. Table 5 displays the proﬁt or loss due to jumps of varying sizes for three-month and one-year variance swaps. the gain from the jump has to be balanced against the subsequent failure of the hedge to capture the smooth variance. Jump size and direction Three-month One-year J = 15% (down) J = 10% (down) J = 5% (down) J = −5% (up) J = −10% (up) J = −20% (up) The Effect of Jumps When Replicating With a Finite Strike Range 101.5 28. Consider again a short position in a variance contract that is being hedged by the variance-capture strategy. even if no further jumps occur.9 −0. TABLE 5. with the stock price now outside the strike range. However. that is hedged with the variance replication strategy of Equation 36 for T=1 year. The proﬁt/loss due to a single jump for a short variance swap with a notional value of $1 per squared variance point. 32 . the constantdollar exposure would cancel the linear part of the stock price change.2 −24. and lead to a convexity gain.4 7. If the log-payoff were replicated perfectly. Although the log-payoff is not being replicated perfectly. Suppose that a downward jump occurs.8 3. the direction of the jump determines whether there is a net proﬁt or loss.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES term is cubic. The net results will depend on the details of the scenario. but it is smaller in size.

such as volatility swaps. But most market participants prefer to quote levels of volatility rather than variance. both theoretically and practically. Naively. With this choice. as we will show. it is variance that emerges naturally from hedged options trading. The replication strategy for the variance swap makes no assumptions about the level of future volatility. it is affected by changes in volatility and its value depends on the volatility of future realized volatility. which still captures the total variance over the life of the log contract. other than assuming that the stock price evolves continuously (without jumps). from a contingent claims or derivatives point of view. the replication strategy for a volatility swap is fundamentally different. To illustrate the issues involved. Changes in volatility have no effect on the strategy. In contrast.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FROM VARIANCE TO VOLATILITY CONTRACTS For most of this note we have focused on valuing and replicating variance swaps. In essence. to value and hedge. In order to approximate a volatility swap struck at K vol . and so we now consider volatility swaps. We see that the actual volatility swap and the approximating variance swap differ appreciably 33 .( σ R – K vol ) 2K vol 2 (EQ 43) This means that 1 ⁄ ( 2K vol ) variance contracts with strike K vol can approximate a volatility swap with a notional $1/(vol point). let’s consider a naive strategy: approximate a volatility swap by statically holding a suitably chosen variance contract. the variance and volatility payoffs agree in value and volatility sensitivity (the ﬁrst derivative with respect to σ R ) when σ R = K vol . variance is the primary underlyer and all other volatility payoffs. volatility itself is a nonlinear function (the square root) of variance and is therefore more difﬁcult. From this perspective. for realized volatilities near K vol . There is no simple replication strategy for synthesizing a volatility swap. we can use the approximation 2 2 1 σ R – K vol ≈ --------------. are best regarded as derivative securities on the variance as underlyer. this would also imply that the fair price of future volatility (the strike for which the volatility swap has zero value) is simply the square root of fair variance K var : K vol = K var (naive estimate) (EQ 44) In Figure 11 we compare the two sides of Equation 43 for Kvol = 30% for different values of the realized volatility. which has payoff σ R – K vol .

some of the risks inherent in the static approximation of a volatility swap by a variance swap could be reduced by dynamically trading new variance contracts throughout the life of the volatility swap. 10 5 payoff 0 -5 20 30 40 -10 -15 σR only when the future realized volatility moves away from K vol . To avoid this arbitrage.( σ R – K vol ) 2K vol This square is always positive. for K vol = 30% . In this way. In order to estimate the size of the convexity bias. the variance swap payoff is always greater than the volatility swap payoff. and therefore the fair strike for the volatility swap. so that with this choice of the fair delivery price for volatility. the straight line in Figure 11 will shift to the left and will not always lie below the parabola. With this choice. The naive estimate of Equations 43 and 44 is not quite correct. you cannot ﬁt a line everywhere with a parabola. Dynamic Replication of a Volatility Swap In principle. Payoff of a volatility swap (straight line) and variance swap (curved line) as a function of realized volatility. The mismatch between the variance and volatility swap payoffs in Equation 43. so that K vol < K var . the variance swap always outperforms the volatility swap. it is necessary to make an assumption about both the level and volatility of future realized volatility. In Appendix D we estimate the expected hedging mismatch and static hedging parameters under the assumption that future realized volatility is normally distributed. we should correct our naive estimate to make the fair strike for the volatility contract lower than the square root of the fair strike for a variance contract. is the 2 1 convexity bias = --------------.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FIGURE 11. This dynamic replication of a volatility swap by means of vari- 34 .

Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES ance swaps would (in principle) produce the payoff of a volatility swap independent of the moves in future volatility. 35 . When there is a liquid market in variance swaps. of course. it is only very recently that such models have been developed [see for example Derman and Kani (1998) and Ledoit (1998)]. The practical implementation of these ideas requires an arbitrage-free model for the stochastic evolution of the volatility surface. Due to the complexity of the mathematics involved. This is closely analogous to replicating a curved stock option payoff by means of delta-hedging using the linear underlying stock price. In practice. there is no market in variance swaps liquid enough to provide a usable underlyer. Taking the analogy further. these models may be useful in hedging volatility swaps and other variance derivatives. the dynamic replication of a volatility swap requires a model for the volatility of volatility. one could imagine that the strategy would call for holding at every instant a “variance-delta” equivalent of variance contracts to hedge a volatility derivative. In the same way that the appropriate option hedge ratio depends on the assumed future volatility of the stock.

In markets with a volatility skew (the real world for most swaps of interest). 36 . Second. our ability to effectively price and hedge volatility swaps is still limited. These formulas enable traders to update price quotes quickly as the market skew changes. this requires a consistent model for stochastic volatility. To fully implement a replication strategy for volatility swaps. one can still value variance swaps by replication. We have explained both the intuitive and the rigorous approach to replication. Once again. we have succeeded in deriving analytic approximations that work well for the swap value under commonly used skew parameterizations.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES CONCLUSIONS AND FUTURE INNOVATIONS We have tried to present a comprehensive and didactic account of both the principles and methods used to value and hedge variance swaps. forwards or futures would lead to the possibility of trading and hedging volatility options. The capped variance swap has embedded in it an option on realized variance. using the rigorous approach. Much work remains to be done in this area. Here. Remarkably. The development of a truly liquid market in volatility swaps. the intuitive approach loses its footing. There are at least two areas where further development is welcome. First. some market participants prefer to enter a capped variance swap or volatility swap that limits the possible loss on the position. we need a consistent stochastic volatility model for options.

v) represents a standard Black-Scholes option of strike K and total variance v = σ τ when the stock price is S.------------------------------2 v 2π and ln ( S ⁄ K ) + v ⁄ 2 d 1 = ---------------------------------------. Vega. Consider a portfolio of standard options ∞ Π(S) = ∫ ρ ( K )O ( S. K . is given by VO = τ where 1 exp ( – d 1 ⁄ 2 ) f ( S.. v ) d x 0 ∫ 37 .K. v ) d x = τ S [ 2ρ ( xS ) + xSρ' ( xS ) ] f ( x.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES APPENDIX A: REPLICATING LOGARITHMIC PAYOFFS Constant Vega Requires Options Weighted Inversely Proportional to the Square of the Strike In this Appendix we derive several results concerning the replication of a logarithmic payoff with portfolios of standard options. v S ∂v ∫ (A 2) 0 The sensitivity of vega to S is ∂V Π ∂S ∞ = τ ∫ ∂ S[ S 0 ∞ ∂ 2 ρ ( xS ) ] f ( x. v The variance sensitivity of the whole portfolio is therefore K V Π ( S ) = τ ρ ( K )Sf ---.. v ) dK 0 (A 1) where O(S. v d K S ∞ 2 2 ∂ K (O) = τSf ---.. v ) = ---------. the sensitivity to the total variance of an individual option O in this portfolio. K .

The ﬁrst segment to the right of S* is equivalent to the payoff of a call option with strike K0. in the second line of the above equation. The number of options is determined by the slope of this segment: f ( K 1c ) – f ( K 0 ) w c ( K 0 ) = ---------------------------------------K 1c – K 0 (A 5) 38 .. Since there is no log-contract traded. which implies ∂ρ = 0 ∂K It was shown in the main text that the realized variance is related to trading a log contract. and we need to determine the number of options for each strike. only a discrete set of option strikes is available for replicating f ( S T ) . It is useful to subtract the linear part (corresponding to the forward contract) and look at the function ST 2 ST – S* f ( S T ) = --. Assume that you can trade call options with strikes K 0 = S * < K 1c < K 2c < K 3c < . we want to represent it in terms of standard options. that is that 2ρ + K The solution to this equation is const ρ = ------------2 K Log Payoff Replication with a Discrete Set of Options (A 3) ∂V Π ∂S = 0 .– log ------T S* S* (A 4) where S* is some reference price...------------------.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES where. we changed the integration variable to x = K ⁄ S . and put options with strikes K 0 = S * > K 1 p > K 2 p > K 3 p > . We can approximate f ( S T ) with a piece-wise linear function as in Figure 11. We want vega to be independent of S. In practice..

p ) = ---------------------------------------------------------. c n–1 i=0 ∑ w c ( K i. c ) – f ( K n. Log-payoff and options portfolio at maturity. the number of call options of strike K n. the second segment looks like a combination of calls with strikes K 0 and K 1c . In general. K2 p K 1p K0 K 1c K2 c Similarly. c is given by f ( K n + 1 . c ) (A 7) The other side of the curve can be built using put options: f ( K n + 1 .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES FIGURE 12. c ) = ------------------------------------------------------. p – K n + 1. p n–1 i=0 ∑ w c ( K i.– K n. c ) w c ( K n. Given that we already hold w c ( K 0 ) options with strike K 0 we need to hold w c ( K 1 ) calls with strike K 1 where f ( K 2c ) – f ( K 1c ) w c ( K 1 ) = ------------------------------------------. p ) – f ( K n.– K n + 1. p ) w p ( K n. p ) (A 8) 39 .– w c ( K 0 ) K 2c – K 1c (A 6) Continuing in this way we can build the entire payoff curve one step at the time. c – K n.

C ( K .b + . Σ0 ) + b + -. ∂ b b = 0 2 ∂ b2 b=0 P ( K .. Σ 0 is at-the-money forward implied volatility and b is the slope of the skew. We parameterize the implied volatility by K – SF Σ ( K ) = Σ 0 – b -----------------S F rT (B 1) where S F = S 0 e is the forward value corresponding to the current spot.P ( K . ∂ b b = 0 2 ∂ b2 b=0 2 2 (B 3) Using this expansion we can formally write an expansion of fair variance in powers of b as follows: ∞ 1 ∂C 2 2 rT S * 1 ∂P ------------dK + dK + K var = Σ 0 + b --.b --. Σ ( b ) ) d K + e K2 rT ∞ ∫S -------. rT – -----.e ------------dK + d K + . Σ0 ) + b 1 2∂P ∂P + -.e – 1 – log -----. Σ ( b ) ) = P ( K ... We start with the general expression for the fair variance discussed in the main text: S* S 0 rT 2 K var = --.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES APPENDIX B: SKEW LINEAR IN STRIKE Here..e T 0 K 2∂b 2∂b S* K b=0 b=0 ∫ ∫ 2 2 ∞ 1 ∂C 1 2 2 rT S * 1 ∂ P -. 1 2∂C ∂C C ( K .+ T S0 S* e rT S * (B 2) ∫0 1 ------. Σ ( b ) ) = C ( K . we derive a formula which gives the approximate value of the variance swap when the skew is linear in strike.. Σ ( b ) ) dK K2 1 * We now expand option prices as a power series in b around a ﬂat implied volatility ( b = 0 ). 0 K2 2 2 2 2 T S* K ∂ b ∂b b = 0 b=0 (B 4) ∫ ∫ 40 ..b + .

.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Here Σ 0 is the fair variance in the “ﬂat world” where volatility is constant and is given by Equation B2 with Σ ( b ) replaced by Σ 0 .– 1 e T 2π 0 K 2 S F ∫ ∂d 1 – d 1 ⁄ 2 1 2 2 rT S T ∞ 1 K 2d -----------.. ------.------.– 1 S ∂b b = 0 F (B 6) The fact that call and put options have the same vega in the BlackScholes framework makes it possible to combine the integrals in Equation B4 into one integral from 0 to ∞ : 2 –d1 ⁄ 2 2 2 rT S T ∞ 1 K dK – K var = Σ 0 – b --. 1 ∂ Σ0 2π 0 K 2 ------2 T SF 2 (B 7) ∫ 41 .Σ 0 T K 2 d 1 = ------------------------------------------Σ0 T where.e -----------.b --. The derivatives which enter Equation B4 are given by ∂P ∂Σ ∂P = . ∂b b = 0 ∂Σ Σ ∂b b = 0 0 ∂ P ∂b b = 0 ∂ C ∂b b = 0 2 2 2 2 2 = ∂ P ∂Σ Σ 0 ∂ C ∂Σ Σ 0 2 2 2 2 ∂Σ ∂ b ∂Σ ∂ b 2 b=0 2 b=0 = The derivatives with respect to volatility are easily calculated using the Black-Scholes formula S T –d1 ⁄ 2 ∂P ∂C = = ------------e ∂Σ Σ ∂Σ Σ 2π 0 0 2 ∂ P ∂Σ Σ 0 2 2 = ∂ C ∂Σ Σ 0 2 2 S T ∂d 1 – d 1 ⁄ 2 = – ------------d 1 e 2π ∂ Σ 0 2 (B 5) SF 1 2 log ------- + -.-------. ∂b b = 0 ∂Σ Σ ∂b b = 0 0 ∂C ∂Σ ∂C = . for the model we are considering here K ∂Σ = – ------.e –1 e d K + .

– 1 . where v 0 = Σ 0 T . so that K var = Σ 0 ( 1 + 3Tb 2 + . We start with the fundamental deﬁnition of the fair delivery variance as the expected value of future realized variance.. b e +e – 2 ( z – v 0 z )e 2π –∞ ∫ The term linear in b vanishes and the term quadratic in b has coefﬁcient 3Σ 0 T .e.σ ( S. change the integraSF 1 2 tion variable to z = log ------.– bd 1 Σ 0 – bx ( 1 + x ) t (B 11) 42 . ) 2 (B 8) 2 We now present an alternative derivation of this result. t ) = --------------------------------------------------------------------------------------------------------------------------------2 2 2 1 1 ( 1 + x ) t – b td 1 + -----------------. First.v 0 ⁄ v 0 ≡ d 1 . Equation B10 can be written as SF Σ 0 – bx – 2br ( 1 + x )t σ 2 ( S. t ) = -----------------------------------------------------------------------------------------------------------------------2 2∂ Σ ∂Σ 2 ∂Σ 2 1 1 – d 1 T + -.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES To evaluate these integrals.+ 2 ∂T ∂K T σ 2 ( S. t ) dt T 0 ∫ (B 9) This can be evaluated approximately as follows. and K 2 then write Equation B7 as 2 ∞ 2 dz 1 – e v 0 z – v 0 ⁄ 2 e – z ⁄ 2 ---------. one can.+ d 1 K ∂ K Σ K T ∂ K ∂ K 2 (B 10) K = S T = t S Denote x = ------. 1 T 2 K var = E --. ------------.+ -.----------------------. + - K var = Σ 0 – b 2Σ 0 –∞ 2π ∫ 2 – v0 z + v0 ⁄ 2 2 ∞ v0 z – v0 ⁄ 2 2 – z ⁄ 2 dz ---------.. i. for example. we use the relation between implied and local volatility: ∂Σ ∂Σ Σ + 2rK --..

Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES where – log ( 1 + x ) 1 d 1 = ----------------------------. t ) in powers of x and calculate the expected value in a lognormal world with volatility Σ 0 using E[ x] = 0 E[ x ] = e E[ x ] = e . ) It is reassuring that these two very different methods lead to the same approximation formula. 2 43 .. Expected values of higher powers of x are easily calculated using 2 2 ( n – n )Σ 0 t ⁄ 2 S n E ------- = e S F 2 3 Σ0 t 2 –1 – 3e Σ0 t 2 2 3Σ 0 t +2 After averaging over the stock price distribution.+ -.( Σ 0 – bx ) t 2 (B 12) We expand σ 2 ( S.. ﬁnally. Tedious calculation leads to the relation K var = Σ 0 ( 1 + 3Tb 2 + ..( Σ 0 – bx ) t . expand the result in powers of the skew slope b .. we average over time and..

2 (C 1) where Σ 0 is the implied volatility of options with ∆ p = – 1 ⁄ 2 (the “50delta volatility”). . One important difference is that now implied volatility is nonlinear in b (since ∆ p depends implicitly on b ) so that second derivatives have an additional term: ∂ P ∂b b = 0 ∂ C ∂b b = 0 2 2 2 2 = ∂ P ∂Σ Σ 0 ∂ C ∂Σ Σ 0 2 2 2 2 ∂Σ ∂ b ∂Σ ∂ b 2 ∂P ∂ Σ + ∂ Σ Σ ∂ b2 b=0 0 b=0 + b=0 2 2 = ∂C ∂ Σ ∂ Σ Σ ∂ b2 0 b=0 2 (C 2) Other derivatives we need are easily calculated: ∂Σ 1 = ∆ p + -∂b b = 0 2 ∂ Σ ∂b b = 0 where ∆ p = – N ( –d1 ) and 2 2 1 ∂∆ p = 2 ∆ p + -.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES APPENDIX C: SKEW LINEAR IN DELTA Here we consider the case where implied volatility varies linearly with delta. the delta of a European-style put. 2 ∂ Σ 0 (C 3) 44 . Such a skew can be parameterized in terms of ∆ p .) 2 To derive the formula for the fair variance we follow the same procedure as in Appendix B. (We could also parametrize the skew in terms of the 1 call delta as Σ ( ∆ c ) = Σ 0 + b ∆ c – -. as 1 Σ ( ∆ p ) = Σ 0 + b ∆ p + -. starting with Equation B2.

e dK 2 ∂ Σ 0 K 2 0 ∞ ∫ Again.e -----------. e dK – T 2π K 2 2 ∞ ∫ 2 0 ∞ 2 1 2 2 rT S T 1 1 2 ∂d 1 – d 1 ⁄ 2 -.b --. d 1 e dK - 2π K 2 2 T ∂ Σ0 2 0 ∫ (C 4) 2 1 1 ∂∆ p – d 1 ⁄ 2 – 2 ------. one can ﬁrst expand e in powers of z and integrate term by term. Since we are eventually interested in expanding the result in powers of v 0 = Σ 0 T . so that K 2 2 ∞ –z ⁄ 2 v0 z – v0 ⁄ 2 dz 1 ---------.is antisymmetric in z to simplify calcula2 tions.( z – v 0 z )e e 2 2π –2 v 0 z – v 0 ⁄ 2 – z 2 dz 1 N ( z ) – -. the fair variance can be written as 2 Σ0 K var = 2 rT S T 1 1 –d1 ⁄ 2 – b --. ∆ p + -.------.+ -.( z – v 0 )e e -----2π 2 –∞ ∫ All these integrals can be evaluated exactly.Σ 0 T Σ0 T 2 Combining these relations. where v 0 = Σ 0 T .+ -.e -----------. ∆ p + -. It is also 1 useful to note that N ( z ) – -.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES SF log ------K 1 d 1 = ---------------.e e 2 2π –∞ K var = 2 Σ0 ∫ b 2 ∞ –∞ ∞ ∫ 2 v 0 z – v 0 ⁄ 2 – z ⁄ 2 dz 1 2 2 ---------N ( z ) – -. integrals can be evaluated by changing the integration variable SF 1 2 to z = log ------.∆ p + -. + – b 2Σ 0 N ( z ) – -.v 0 ⁄ v 0 ≡ d 1 . In addition the following results are useful: v0 z – v0 ⁄ 2 2 45 .------.

..= -----------------.– -. Σc ( bc ) ) dK K2 1 * 46 .= ----------------n 2 2π 2 2π ∂ a a a + b 2 (C 5) n n ∫z 0 ∞ 2n – az ⁄ 2 2 e n 2 n ( –2 ) ∂ 1 a + 2b 1 2 dz π ---------. 1 Σ p ( ∆ p ) = Σ 0 + b p ∆ p + -. π 12 (C 6) Two. Σ p ( b p ) ) d K + e K2 rT ∞ ∫S -------.---------.= ------------2π ∂ a n a 2 2π a n n ∫ 0 ∞ z 2n + 1 – az ⁄ 2 2 e ( –2 ) b ∂ 1 1 dz ----------------------N ( bz ) – -.P ( K .---------.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES ∞ ∫z 0 ∞ 2n – az ⁄ 2 2 e ( –2 ) ∂ 1 b 1 dz -----.e.arctan -----N ( bz ) – -.+ .N ( bz ) – -2π ∂ a n a 2 4 2π a ∫ 0 z 2n + 1 – az ⁄ 2 2 e n n b 1 ( –2 ) b ∂ 1 2 dz ----------------------.C ( K .. arctan ------------------.= -------------------3⁄2 n 2 2 2π ( 2π ) ∂ a a a + b2 a+b After evaluating all integrals we ﬁnd the ﬁnal answer to be 2 2 T 1 2 -b K var = Σ 0 + bΣ 0 --.+ ----.Slope Model Our calculations can easily be generalized to the model where the slope of the skew is different for put and call options. 2 1 Σ c ( ∆ c ) = Σ 0 + b c ∆ c – -. i. N ( bz ) – -. rT – -----. arctan ----------------------.+ T S0 S* e rT S * (C 8) ∫0 1 ------.≤ ∆ p ≤ 0 2 1 0 ≤ ∆ c ≤ -2 for for (C 7) We now brieﬂy sketch the derivation emphasizing only the differences with the above detailed calculations. . 2 1 – -.e – 1 – log -----.---------. We start with the same fundamental expression: S* S 0 rT 2 K var = --.

. Σ 0 --. Evaluating all integrals as above we ﬁnd 2 Σ0 K var = b p + bc 1 b p + bc 1 T + -. Note that by changing the sign of b c we turn the implied skew into a smile.+ . Note that we should choose S* so that S* = S F e –Σ0 T ⁄ 2 2 This ensures that we use the put (call) parameterization in Equation C7 for strikes below (above) S*..Σ 0 ( b p – b c ) + Σ 0 -----------------. for b p = b c this reduces to the result for single slope given in Equation C6.. + ----. as given by Equation C7. 12 2 4 2 π 2 2 (C 9) Obviously.-----------------. We expand put option prices in powers of b p and call option prices in powers of b c .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES We use different implied volatility parameterizations for put and call options. 47 .

In the section From Variance to Volatility Contracts on page 33. Given a view on both the direction and volatility of future volatility. as closely as possible. while the target of the replication is the realized volatility ( Σ T ). with mean Σ and standard deviation σ Σ : Σ T ∼ N ( Σ. we will show that it is possible to pick the strike and notional size of a variance contract to match the payoff of a volatility contract. on average. the expected squared replication error is given by: 48 . We want to approximate the volatility as a function of the variance by writing Σ T ≈ aΣ T + b 2 (D 1) and choose a and b to minimize the expected squared deviation of the two sides of Equation D1: 2 min E [ ( Σ T – aΣ T – b ) 2 ] (D 2) Differentiation leads to the following equations for the coefﬁcients a and b : E [ Σ T ] = aE [ Σ T ] + b 3 4 2 E [ Σ T ] = aE [ Σ T ] + bE [ Σ T ] 2 (D 3) The distribution of future volatility could be assumed to be normal. unlike the variance swap. This strategy will replicate only on average.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES APPENDIX D: STATIC AND DYNAMIC REPLICATION OF A VOLATILITY SWAP We have argued that volatility swaps are fundamentally different from variance swaps and that. 2 The hedging instrument is the realized variance ( Σ T ). there is no simple replicating strategy to synthetically create a volatility swap. we showed that attempting to create a volatility swap from a variance swap by means of a “buy-and-hold” strategy invariably leads to misreplication. The extent of the replication mismatch will depend on how close the realized volatility is to its expected value. since this amounts to trying to ﬁt a linear payoff (the volatility payoff) with a quadratic payoff (the variance swap). σ Σ ) (D 4) This model only makes sense if the probability of negative volatilities is negligible.

the hedging coefﬁcients are 1 a = -------------------2 σΣ 2Σ + -----Σ Σ b = ---------------2 σΣ 2 + -----Σ2 and the expected squared replication error is: 2 σΣ 2 2 min E [ ( Σ T – aΣ T – b ) ] = ------------------2Σ 2 1 + --------2 σΣ (D 6) (D 7) 49 .Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES 2 min E [ ( Σ T – aΣ T – b ) ] = Var ( Σ T ) [ 1 – ( corr ( Σ T . Σ T ) ) 2 ] 2 2 (D 5) For realized volatilities distributed normally as in Equation D4.

61110. Kani and J. Vol.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES REFERENCES Carr. 74-80. Derman. and I. 2. Kani (1998). and J. Nelken. in The Handbook of Exotic Options. A. Working Paper. A. E. Zou (1996). Global Derivatives (July) Quarterly Review. No. Financial Analyst Journal. E. The Log Contract: A new instrument to hedge volatility. B. edited by R. Derman. Derman. Goldman. in Volatility: New Estimation Techniques for Pricing Derivatives. E. No. 32-39. RISK 7. Investing in Volatility. 200-212. The Local Volatility Surface.. Stochastic Implied Trees: Arbitrage Pricing with Stochastic Term and Strike Structure of Volatility. (1994). edited by I. October. Riding on a Smile. Ledoit. Derman. O. 25-36. Pirasteh.. Dupire. Derman. Winter. Kani (1994). Goldman.. I. The Log Contract and Other Power Contracts. I. 1. McClure. Kamal. International Journal of Theoretical and Applied Finance. Los Angeles. Pricing with a Smile. No. Kani. Zou (1996). Neuberger. P. July/August. E. Kamal. and P. M. and D. University of California. Sachs & Co. Madan (1998). and J. Neuberger. Relative Price of Options with Stochastic Volatility. 18-20. 1. 1. and I. J. Santa-Clara (1998). Jarrow. (1994). Equity Derivatives Research. M. RISK 7. The Anderson Graduate Schools of Management. (1996). I. 417-427. 50 . E. Sachs & Co. Zou (1996). Towards a Theory of Volatility Trading. Kani. Valuing Contracts with Payoffs Based on Realized Volatility. Journal of Portfolio Management. C. Quantitative Strategies Research Notes.

Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES SELECTED QUANTITATIVE STRATEGIES PUBLICATIONS June 1990 Understanding Guaranteed Exchange-Rate Contracts In Foreign Stock Investments Emanuel Derman. Cyrus Pirasteh and Joseph Zou Jan. 1992 Mar. Iraj Kani. Trading and Hedging Local Volatility Iraj Kani. 1995 Feb. 1992 June 1993 Jan. 1996 Aug. 1996 Oct. Iraj Kani and Joseph Z. Zou Implied Trinomial Trees of the Volatility Smile Emanuel Derman. Iraj Kani. John McClure. Piotr Karasinski and Jeffrey Wecker Valuing and Hedging Outperformance Options Emanuel Derman Pay-On-Exercise Options Emanuel Derman and Iraj Kani The Ins and Outs of Barrier Options Emanuel Derman and Iraj Kani The Volatility Smile and Its Implied Tree Emanuel Derman and Iraj Kani Static Options Replication Emanuel Derman. Deniz Ergener and Iraj Kani Enhanced Numerical Methods for Options with Barriers Emanuel Derman. Emanuel Derman and Michael Kamal Investing in Volatility Emanuel Derman. Michael Kamal. Deniz Ergener and Indrajit Bardhan The Local Volatility Surface: Unlocking the Information in Index Option Prices Emanuel Derman. 1996 Apr. 1994 May 1994 May 1995 Dec. Iraj Kani and Neil Chriss Model Risk Emanuel Derman. 1996 51 .

1997 Sept. 1999 52 . Iraj Kani and Joseph Zou Stochastic Implied Trees: Arbitrage Pricing with Stochastic Term and Strike Structure of Volatility Emanuel Derman and Iraj Kani The Patterns of Change in Implied Index Volatilities Michael Kamal and Emanuel Derman Predicting the Response of Implied Volatility to Large Index Moves: An October 1997 S&P Case Study Emanuel Derman and Joe Zou How to Value and Hedge Options on Foreign Indexes Kresimir Demeterﬁ Regimes of Volatility: Some Observations on the Variation of S&P 500 Implied Volatilities Emanuel Derman Apr.Goldman Sachs QUANTITATIVE STRATEGIES RESEARCH NOTES Apr. 1997 Is the Volatility Skew Fair? Emanuel Derman. 1998 Jan. 1997 Nov. Michael Kamal. 1997 Sept.

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