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OVDV Equity Volatility Surface

Equity Implied Volatility Surface

Changrong Cui and David Frank Quantitative Research and Development, Equities Team June 21, 2011 Version 3.6

OVDV Equity Volatility Surface

This document describes the construction of the equity volatility surfaces shown in the function OVDV. Volatility surface construction involves data ltering, implied forward and implied dividend calculation, and option data tting. We discuss each of these steps in separate sections below. In the option data tting step, our method is based on the mixture of lognormal distributions. At the end of this document we present the connection between the lognormal mixture method and stochastic volatility models.

Data Filtering
We determine whether to use bid/ask or settlement data as follows: 1. For each maturity, the bid/ask data at the maturity is deemed to be good if at least 10% of the quotes and at least 3 options have valid bid/ask prices. 2. Use bid/ask data to build the surface if at least 10% of maturities or at least 3 maturities have good bid/ask data; otherwise use exchange settlement data (last). The data is then ltered as follows: 1. Filter out maturities that are too short. Currently the threshold is 7 days. 2. Eliminate in-the-money options (we use only out-of-the-money options for the surface except for the implied forward computation). 3. Eliminate last data older than 0.001 years. 4. Eliminate bad price data with too small bid/ask/last prices or too wide bid/ask spreads. 5. To ensure monotonicity of prices, we take the longest increasing/decreasing subsequence from call/put prices at each maturity and throw out the remainder. 6. At a given maturity, we calculate implied volatilities from mid prices (when using bid/ask) or from settlement prices. Then we compare each implied volatility to the median of all implied volatilities. We eliminate those strikes whose implied volatilities are outside a certain range. Currently the range is taken as 0.2 to 5.0 times the median volatility. 7. After all valid strikes at all maturities have been found, we check the number of strikes at each maturity. Again, we compare the number of strikes of each individual maturity to the median value across all maturities. If the number of strikes is below 20% of the median, we lter out this maturity. 2

OVDV Equity Volatility Surface

Implied Forwards and Dividends

We compute option implied forwards and dividends as follows. We take as input a list of declared dividends (dates and cash amounts) and a dividend schedule (dates and weights between discrete (cash or proportional) vs. continuous yield). For maturities that have no scheduled dividend between the current maturity and previous maturity, the forward is calculated from the forward at the previous maturity and the yield curve. For other maturities (rolling forward), implied dividends and implied forwards are calculated using the following iterative method: 1. Start with the forward computed from input dividends and the yield curve as an initial guess. 2. If the the options have American-style exercise, for each strike, compute implied volatilities from call and put prices, and then compute European call and put prices from implied volatilities. 3. Now using only European call and put prices, nd up to 20 put-call pairs starting from the forward and moving outwards to both directions. Let {fi } be the forwards, calculated from put-call parity: forward = call - put + strike. 4. Calculate the median fM ED of the {fi }. Keep up to 10 forwards closest to the median, and average those forwards; that is the estimate of the forward. 5. If the original option prices were European, stop here. Otherwise, compare the implied forward in (4) with the old forward calculated in (1). If the relative error is smaller than a given threshold, then stop. Otherwise go back to (1), replacing the original dividends with the newly computed dividends. Finally, let tn be the last given discrete dividend time. If there are additional option maturities left after dividends have been implied at tn then continuous dividend yields will be implied at those maturities using the method described in the next section on option data tting. If, on the other hand, the last discrete dividend that can be implied is at time tm < tn , then dividends are extrapolated for t > tm as continuous dividend yield using equivalent yield from discrete dividend in the last one year period, i.e. dividend yield q such that Ftm = Ftmj e(rq)(tm tmj ) where tm tmj 1.0, Ftm and Ftmj are forwards. If there is only less than a years implied dividends available, then tmj can go back to historical dividend time. Use of Discrete Absolute, Discrete Proportional, and Continuous Dividends For each (discrete) dividend time (measured from today) 0 = t0 , t1 , . . . , tn , tn+1 = T d d ; for stock (proportional) div, . . . , n we are given weights - for cash dividends: 1 y q y q idends: 1 , . . . , n and for (continuous) yields: 1 , . . . , n . Those weights determine the percentage of different dividends at time ti . The sum of all three weights 3

OVDV Equity Volatility Surface

y q d d i + i + i = 1. Currently for single name stocks all i are set to 1 and for indices q all i are set to 1. In other words, we currently imply only discrete dividends for single name stocks and only continuous dividend yields for indices.

Let Fi denote the forward at time ti . We will imply out the dividend amounts in cash di and in stock yi paid at ti , as well as continuous yield q applying over the period (0, T ). We do this using the following strategy: from 1. Imply d Ft = F0 e 2. Imply q from F0 e 3. Imply d from FT = F0 e(rq)T d 4. For i = 1, . . . , n do (a) Let di = d
d i y d i + i (rq )T rT n i=1 n i=1 n i=1

er(T ti )

= F0 e


q r (T ti ) i e

e(rq)(T ti )

(b) Let Fi = Fi1 e(rq)(ti ti1 ) d (c) Imply yi from Fi = Fi1 e(rq)(ti ti1 ) (1 yi ) di

Option Data Fitting - Mixture of Lognormal Distributions

The mixture of lognormal distribution was proposed by [Brigo and Mercurio (2002)] and the basic idea is to assume that the risk-neutral probability density function of the spot price at any maturity is a weighted sum of some lognormal density functions with different means and variances. An obvious advantage over other parametric approaches is that the density function is positive and therefore we never have call spread artibrage or buttery arbitrage. Another advantage is that pricing a vanilla European option only needs a few Black-Scholes formula calculations, which is very accurate and fast. To quantify the description, the risk-neutral probability density function of the stock price at any future time T > 0 is assumed to be in the following form pdf (T, S ) = where 4
N l=1

pl (T ) lognormalpdf (S, l (T )F (T ), l (T ))

OVDV Equity Volatility Surface N is the number of lognormals, F (T ) is the forward price, pl (T ) is the time-dependent weight of the l-th lognormal, l (T ) is the time-dependent multiplicative means of the l-th lognormal, l (T ) is the time-dependent deviation of the l-th lognormal. We require pl (T ) > 0, l (T ) > 0, l (T ) > 0 l pl (T ) 1. If the sum of weights is less than 1, then then there is a point mass at zero which represents a probablity of default. A strictly positive default probability could help to t a high skew in the low strike range, which is common in equities market. l pl (T )l (T ) = 1. The weighted sum of means is the expectation of ST and it must be equal to the forward price. Now, the price of a European call option with maturity T and strike K can be written as N pl (T ) blsprice(l (T )S0 , K, r, T, l (T )/ T ) C (T, K ) =

and we can get the implied volatility at any point using this call price formula, where blsprice(S, K, r, T, ) is the Black-Scholes price of a call option with spot S , strike K , risk-free rate r, time to expiration T and volatility . Figure 1 shows an example of the mixture of two lognormals. The mixed lognormal has larger density in the middle range and fatter tail as shown in Figure 2. Also, the mixed lognormal produces the volatility smile as shown in Figure 3. It is difcult to have a perfect answer for the choice of N , the number of lognormals. If N is too small, the volatility smile would not have enough exibility to t the market data; if N is too large, there will be an overtting issue. In practice, we choose N = 4 and use a more rigid structure for the four lognormals when there are not a sufcient number of valid options. We now describe the optimization which nds the mixed lognormal parameters best tting the market prices. The target of our non-linear least square problem is European option prices. If the market options are not European-style exercise, then we have already converted the market prices to European prices using the methodology described in the section Implied Forwards and Dividends. The optimization 5

OVDV Equity Volatility Surface

Density Functions 1.5 Mixed Lognormal Lognormal





Figure 1. Density functions for mixed lognormals and one lognormal. N = 2, 1 = 0.95, 2 = 1.05, 1 = 0.40, 2 = 0.20, p1 = p2 = 0.5, T = 1, F = 1. The deviation of the single lognormal is chosen to match the variance of ST in the mixed lognormal.

OVDV Equity Volatility Surface

Density Functions Tail 0.05 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 2 2.2 2.4 2.6 2.8 3 Mixed Lognormal Lognormal

Figure 2. Density function Tails, Figure 1 enlarged.

OVDV Equity Volatility Surface

Volatility Smile 0.42 Mixed Lognormal Lognormal 0.4









Figure 3. Volatility Smile Produced by Mixed Lognormal.

OVDV Equity Volatility Surface is done maturity-by-maturity, except that if the optimizations among different market maturities are done completely independently, there may be calendar arbitrage. To control that, we use constraints on the lognormal parameters of different maturities, for example, for each l = 1, , N ,
mkt mkt mkt 0 < l (T1 ) < l (T2 ) < < l (Tn ) mkt

With this constraint, we can build an increasing curve l (T ) from market maturity points. Similarly, we can have the other two classes of curves l (T ) and pl (T ), l = 1, , N . Having constructed the curves pl (T ), l (T ) and l (T ), we can then compute the surface volatility given any strike and maturity by interpolating or extrapolating the curves to determine the parameters at the required point, computing the weighted sum of Black-Scholes prices, and inverting to get the required implied volatility. Having the mid implied volatility, we calculate the bid/ask volatility spread using linear interpolation and at extrapolation in strike dimension and Hermite interpolation and at extrapolation in maturity dimension.

Connection Between Lognormal Mixture and Stochastic Volatility

We restate a result in [Fouque, Papanicolaou and Sircar (2000)] to show that the mixed lognormal model is an approximation to a wide range of stochastic volatility model. Consider a stochastic volatility model dSt = rdt + t ( 1 2 dWt + dZt ) St t = f (Yt ) dYt = (t, Yt )dt + (t, Yt )dZt Then by Itos formula, 1 2 d(ln St ) = (r t )dt + t ( 1 2 dWt + dZt ) 2 Given a path of the second Brownian motion {Zt }, {Yt } is deterministic and so is {t } and therefore T T T 1 2 2 t dWt t d Zt + 1 ln ST = ln S0 + (r t )dt + 2 0 0 0 is normally distributed with mean ( ) T 1 2 ln S0 + r T + t d Zt 2 0 9

OVDV Equity Volatility Surface and variance



1 = T

T 2 (1 2 )t dt


) ( t 1 2 t 2 t = exp s dZs s ds 2 0 0

2 at each realization of {Y }. When the number of lognormals goes to volatility t innity, the discrete lognormals will converge to this model.

Then ST is continuously-mixed-lognormal distributed, with multiplicative drift T and

[Brigo and Mercurio (2002)] D. Brigo and F. Mercurio (2002), Lognormal-Mixture Dynamics and Calibration to Market Volatility Smiles, International Journal of Theoretical & Applied Finance 5(4), 427-446. [Fouque, Papanicolaou and Sircar (2000)] J-P. Fouque, G. Papanicolaou, K. R. Sircar (2000), Derivatives in Financial Markets with Stochastic Volatility, Cambridge University Press