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Geodesic strikes

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You are on page 1of 6

Peter Jckel

a

First version: 28th July 2012

This version: 28th July 2012

Abstract

In practice, it is not uncommon for X to be the market price of a standard investment asset such as an

equity share, denominated in its domestic currency

DOM, and for Y to be an FX rate that converts the

nal investment asset value to a target currency TAR.

As a consequence of the natural direction of the FX

rate, i.e., DOMTAR, meaning the value of one DOM

currency unit expressed in units of TAR, the valuation of a composite option may also incur a quanto

eect since the asset X and the FX rate DOMTAR

cannot be martingales in the same measure, and this

has to be taken into account. For the purpose of this

article, however, we shall assume that all involved

underlyings are martingales in the same measure. In

practice, this may mean that we have to determine

an eective quanto forward for the asset X in the target currency TAR by other means of approximation

prior to being able to commence with our eective

geodesic strike procedure. We shall return to this

point at the end of section 3.

Basket options are, conventionally, derivatives

with a payo of the form

most relevant or eective strikes for the assessment

of appropriate implied volatilities used for the valuation of composite, basket, Asian, and spread options

following the spirit of geodesic strikes [ABOBF02].

Introduction

trading, we often also encounter composite, basket,

Asian, and spread options. Whilst their respective

payo rules do in principle warrant treating them as

genuinely exotic options, it is often desirable to use

a simple approximation for the sake of tractability.

A popular approach is to use a relatively simple valuation methodology based on multivariate geometric Brownian motion, the well-known Black-ScholesMerton framework, and to nd a suitable implied

volatility (or term structure thereof) for each underlying selected by the concept of a most relevant, or

eective, strike for each observation date. For a plain

vanilla option, clearly, the volatility must be taken

from the implied volatility surface at the options expiry date and at the options strike. For composite,

basket, Asian, and spread options, the most suitable

strike for the looking up of implied volatility is not

necessarily as obvious. In this document, we suggest

a systematic procedure that addresses this question.

( [

K])+ .

(2.2)

of a number of underlyings, whence it is also referred

to as an arithmetic basket option. In contrast, whilst

rarely traded, there is also the geometric basket option

( [ i Xiwi (T ) K])+ .

(2.3)

Asian options are in the framework of multivariate

geometric Brownian motion merely a special case of

arithmetic basket options in that the xings that contribute to the average are from the same underlying,

but for dierent observation times:

spread options

which pays at a future payment date Tpay the payo

( [X (T ) Y (T ) K])+ ,

i wi Xi (T )

( [

i wi X

(Ti ) K])+ .

(2.4)

( [(X(T ) Y (T )) K])+

(2.5)

with = 1 for calls and puts, based on two underlyings X and Y observed on the expiry date T Tpay . for two underlyings X and Y .

By allowing the subscript i on an observation index

Xi to indicate a specic underlying as well as xing

Key words and phrases. eective strikes, geodesic, compostime, and by additionally permitting weights to be

ite options, basket options, Asian options, spread options.

1

negative as well as positive, it is clear that all of bas- relating to the dispersion matrix A according to

ket, Asian, and spread options take on the form of

C =AA .

(3.5)

an arithmetic average option

(2.6) The approximation of eective geodesic strikes is now

to nd a set of logarithmic shift coecients , which

Equally, it is evident that both composite and geo- relates to the eective strike for underlying #i as

metric basket options appear as a geometric average

Ki = Xi ei ,

(3.6)

option

wi

( [ i Xi K])+ .

(2.7)

such that the multivariate probability density of

Subsequently, we will therefore concentrate on these under the joint normal law with

two generic cases: geometric and arithmetic average

options.

=C

(3.7)

( [

i wi Xi

K])+ .

Geodesic strikes

f (K ) = K .

The formal derivation of the procedure for the calculation geodesic strikes in [ABOBF02] involves concepts of projection onto an eective local volatility

representation of a basket process for large deviations, as well as Varadhans geodesic theorem [Var67],

and is rather technical. In this document, we shall

attempt to obtain a similar result with a somewhat

less rigorous, though tractable, argument, bearing in

mind that the sole purpose of the exercise is to arrive at a set of suitably chosen eective strikes for

the lookup of implied volatilities from the underlyings implied volatility smiles. These volatilities are

then to be used in whatever near-vanilla approximation that is chosen for the respective target product.

We emphasize that it is clear that this process cannot

possibly arrive at a sophisticated exotic product pricing framework. Instead, it merely is intended to give

a procedure that suces for the simplistic, but very

fast, valuation of some near-vanilla products whilst

preserving some sensible consistency conditions.

The starting point is that all of the involved

stochastic nancial observables X are governed by

a joint log-normal law, and that there is a critical

level K for a function f () of the nancial observables, identied by the fact that the payout is of the

form

( (f (X) K))+ .

(3.1)

= arg max () f (K ) = K

aij zj

() :=

e 2

C 1

(2)n |C|

(3.10)

The log-bilinear form of (3.10) allows us to simplify (3.9) to

z = arg min z z f (K ) = K

z

(3.11)

with

= A z .

(3.12)

As we shall see below, it turns out that the eective strikes themselves depend on (implied) volatilities. This makes the task of eective geodesic strike

calculation ultimately an implicit problem, since we

need the eective strikes to be able to look up the

implied volatilities in the rst place. In practice, we

resolve this by the approximation that all volatilities that show up in the eective strike formul are

to be taken as at-the-forward implied volatilities. In

this context, we recall that we mentioned at the end

of the rst paragraph in section 2 that, when some

of the underlyings require translation into the target

valuation measure, an approximation for this translation of forward and implied volatility smile has to

be employed separately and prior to the invocation of

the eective geodesic strike procedure. When choosing the quanto-translation procedure, it is useful to

bear in mind that the subsequent geodesic strike selection is only an approximation for the sake of analytic tractability for a range of near-vanilla products,

(3.2)

with

X= X ,

(3.9)

with

transform the vector of nancial variables X to a

vector of independent standard Gaussian variables z

according to

Xi = Xi e 2 cii +

(3.8)

(3.3)

matrix, and the log-covariance matrix C whose elements are

cij = ln Xi , ln Xj

(3.4)

2

gives us

for the quanto translation in line with the overall

level of the chain of approximations. We emphasize,

however, that whilst the geodesic strike procedure is

only an approximation, its purpose is to be consistent

and accurate in a certain asymptotic sense, namely

that of the local volatility projection for large deviations, i.e, for out-of-the-money options, and that

of the geodesic distance asymptotics of [ABOBF02]

and [Var67].

3.1

Ki = Xi ei

with

i :=

Xiwi .

(X) =

Az

ln

XY

X (X +XY Y )

2

2

X +2X XY Y +Y

KY = Y e

ln

XY

Y (Y +XY X )

2

2

X +2X XY Y +Y

(3.25)

lim KX =

(3.14)

Y 0

(3.26)

which is consistent with the exact plain vanilla op(3.15) tion we arrive at in this limit for a composite option,

and we obtain of course the symmetric equivalent for

X 0. When correlation is zero, the log-moneyness

of the composite option translates to log-moneyness

(3.16) of the underlyings as a function of the log-volatilityratio

:= 2 ln(X /Y )

(3.27)

(3.17) according to the logistic functions

with

Xiwi

G :=

(3.24)

w C w

to a few benchmark cases. First, let us consider the

case when Y 0. In that case, we have

K = G ew

j cij wj

KX = X e

geometric

average

as dened in (2.1), we have wi 1 and

(3.23)

which we write as

w A z = 0

with

:= ln(K/G) .

constraint (3.16), we solve the Lagrange multiplier

problem

z = arg min z z + w A z

z

X =

1 + e

Y =

and

1 + e

(3.28)

(3.18)

*

X

From

*

Y

/2

z z+ w Az

=0

z=z

(3.19)

0

-4

we have

z =

A w

2

-3

-2

-1

zero correlation according to equation (3.28).

(3.20)

metry X () + Y () = 1 which is intuitively appealing. Also, when volatilities are equal, the log

= 2

.

(3.21) moneyness is equally distributed over both underw C w

lyings, which is again what one would intuitively expect from a sensible eective strike approximation

Upon resubstitution into (3.20), we arrive at

formula. In the limit of XY = 1, we obtain

A w

z =

.

(3.22)

X =

and

Y =

(3.29)

w C w

2

1+e

1 + e2

k = K , and the contribution of the continuous part

will be largely centered near k and tail o rapidly

*

X

as k due to the rapid decay of out-of-the

*

money options value B(X, k , (k )), assuming that

Y

/2

(k ) rises only moderately such as would be consis

tent with nite second and higher moments. Hence,

while the selection of an eective implied volatility

-4

-3

-2

-1

0

1

2

3

4

produce the smile dependence one can obtain from

Figure 2: Underlying log-moneyness for composite options with the continuous integration over all strikes to innity (3.33), we at least capture the fact that the domiperfect correlation according to equation (3.29).

nant contribution does indeed come from the implied

which we display in gure 2. We see in gure 2 that

with diverging volatilities, i.e., as diverges from 0,

3.2 Geodesic strikes for arithmetic averthe underlyings log-moneyness is less rapidly shifted

age options

from an equal split at = 0 to just one of the underlyings, as indicated by the lesser slope near zero, Here, we have

when comparing with the case XY = 0 in gure 1.

f

(X) =

wi Xi .

(3.34)

This behaviour is also intuitively desirable.

arithmetic

average

i

Finally, we consider the case of perfect correlation

given by the option under consideration actually be- The constraint (3.8) is

ing a square option

g(z ) = K

(3.35)

X2 K + .

(3.30)

with

In comparison, by a standard argument of continuous

g(z) :=

wi Xi e j aij zj .

(3.36)

replication, we can value this option based on the

i

Taylor expansion with complete remainder for any

From

smooth function h(x) around k

z z + g(z) K

h (z)(x z) dz

=0

(3.37)

z=z

(3.31) we obtain

whence

zi +

ali wl Xl e

alj zj

= 0

(3.38)

the elements of the vector z by the aid of a nonk

linear root nding algorithm such as [DGW81]. The

Choosing h(X) = X 2 K and k := K , and taking eective geodesic strikes are then

the expectation over X, we obtain for the call option

Ki = Xi ei

(3.39)

2

E X K +

(3.33)

with

= A z .

(3.40)

k

+

h (z)(x z)+ dz .

(3.32)

tion function for forward X, strike K, and implied

volatility . Equation (3.33) has two parts. First,

absolute weight 2k. Second, we have a continuum of

vanilla call options for all strikes above k with density 2. For signicantly out-of-the-money options, as

stipulated by the large deviations asymptotics at the

heart of the geodesic argument, the dominant part

will be the discretely weighted call option struck at

and (3.38), we can either use zero, or proceed to nd

an expansion as follows.

Dening

X :=

wi Xi

:= ln(K/X) , (3.41)

and

we rewrite (3.35) as

wi Xi e

i

aij zj

= X e .

(3.42)

whence

= 0 + (1) + 2 (2) +

z = 0 + z (1) + 2 z (2) +

1

2

z (2) =

(3.43)

(3.44)

1+2

A

C

(3.45) z =

A A

C C

1

3

2

C

( C )

A

C

(3.56)

Substituting (3.44) into (3.42) and expanding in

with 1 denoting the identity matrix. This nally

around 0 gives

gives us the second order expansion

(1)

i 1 +

i

1

2

(2)

aij zj + 2 zj

(1) 2

aij zj

+ 2

= 1 + + 1 2 + O 3

2

1

2

(3.57)

1+2

A A

C C

1

3

2

C

( C )

A

+ O 3 .

C

where we have used the normalized eective weights As an example, we show in gure 3 the rst and second order expansion solutions for a monthly observed

wi Xi

i := .

(3.46) Asian option of one year maturity in comparison with

X

a numerical solution for an arbitrarily chosen term

2 , equa- structure of arbitrage-free implied volatility.

Matching coecients up to order O

tion (3.45) gives

35%

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

T

i i

= 1

A z (1) = 1

30%

(3.47)

(3.48)

-0.5

25%

-1

20%

Az

(2)

1

2

1

2

(1)

A Az

(1)

(T )

, (3.49)

15%

-1.5

with the matrix dened to be diagonal and its elements being equal to those of . Expanding (3.38)

in yields

(1)

+ 2 zi

(1)

NL2SOL

5%

(3.50)

(2)

wl Xl ali 1 +

= O

10%

Lognormal expansion, second order

-2

-2.5

(2)

zi

of rst and second order as given in (3.57) in comparison with

a numerical solution by the aid of NL2SOL of equations (3.35)

and (3.38) for a monthly observed Asian option of one year

maturity with an arbitrarily chosen term structure of arbitragefree implied volatility. All forwards were equal to 1, and the

strike was at 0.3.

(1)

alj zj

z (1) = (1) X A

0%

(3.51)

undened, and none of the above equations can be

(3.52)

evaluated. In that case, it may be better to use an

by matching coecients of up to second order. expansion in

:= K X ,

(3.58)

1

1

(1) =

X C

(3.53)

z =

C

X

and hence

z (1) =

A

.

C

i.e.,

(3.54)

zi =

K X

vX

aij wj Xj

(3.59)

wi Xi cij wj Xj .

(3.60)

with

1

1 3 C C

1

(2) =

2

2 2

X C

( C )

vX :=

(3.55)

i,j

Acknowledgement

The author is grateful to Charles-Henri Roubinet,

Head of Quantitative Research at VTB Capital, for

pointing out the results in [ABOBF02], and for authorizing the release of the ndings presented here

(originally from mid 2011, and rst completed with

the second order expansion in March 2012) into the

public domain.

References

[ABOBF02] M. Avellaneda, D. Boyer-Olson, J. Busca, and P. Friz.

Reconstructing volatility. Risk, pages 9195, October 2002.

www.math.nyu.edu/faculty/avellane/

Avellaneda.pdf.

[DGW81]

an adaptive nonlinear least-squares algorithm. ACM

Transactions on Mathematical Software, 7:348368,

1981. www.netlib.org/toms/573.

[Var67]

S. Varadhan. Diusion processes in a small time interval. Communications on Pure and Applied Mathematics, 20(4):659685, November 1967.

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