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1.1 The Black-Scholes Formula and Volatility Smiles

Consider the pricing of a call option with payoff

C

T

= (S

T

K)

+

.

Let us work with forward prices. The forward price of the underlying asset is

F

T

t

=

S

t

P(t, T)

,

where P(t, T) is the time-t price of discount bond with maturity T. It is well known in

nance that F

T

t

is modeled as a lognormal martingale under the T-forward measure, Q

T

,

such that

dF

T

t

= F

T

t

F

dW

T

t

,

where

F

is the volatility of the forward price and W

T

t

is a Brownian motion under the

T-forward measure Q

T

. The solution to the above SDE is

F

T

t

= F

T

t

exp

_

1

2

2

F

+

F

(W

T

T

W

T

t

)

_

= F

T

t

exp

_

1

2

2

F

+

F

_

,

where = T t is the time to maturity and is a standard normal random variable under

Q

T

. Since all forward prices are martingale under the forward measure, we have, for the

forward price of the option,

C

t

P(t, T)

= E

Q

T

_

_

F

T

t

K

_

+

_

= E

Q

T

_

F

T

t

1

F

T

T

>K

_

KE

Q

T

_

1

F

T

T

>K

_

.

1

2 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

The two expectation will be evaluated consecutively. For the second expectation we have

E

Q

T

_

1

F

T

T

>K

_

= Prob(F

T

t

> K)

= Prob

_

>

ln

F

T

t

K

1

2

2

F

_

= (d

2

),

(1.1.1)

where

(x) =

1

2

_

x

x

2

2

dx,

and

d

2

=

ln

F

T

t

K

1

2

2

F

.

For the rst expectation we have

E

Q

T

_

F

T

t

1

F

T

T

>K

_

=

1

2

_

+

d

2

F

T

t

exp

_

1

2

2

F

+

F

x

_

e

x

2

2

dx

=

F

T

t

2

_

+

d

2

y

2

2

dy = F

T

t

(d

1

),

(1.1.2)

where

d

1

= d

2

+

F

.

Combining (1.1.1) and (1.1.2) we arrive at the Blacks formula:

C

t

= P(t, T)

_

F

T

t

(d

1

) K(d

2

)

_

= S

t

(d

1

) KP(t, T)(d

2

).

(1.1.3)

Put options, with terminal payoff of the form

P

T

= (K S

t

)

+

,

can be priced by call-put parity:

P

t

= C

t

(S t P(t, T)K)

= S

t

((d

1

) 1) +KP(t, T)(1 (d

2

))

= KP(t, T)(d

2

) S

t

(d

1

).

(1.1.4)

Note that, due to arbitrage, the put call parity is well observed in the market place.

Given the market prices of call and put options, we can solve for the implied volatil-

ities, numerically, and thus obtain {(K/S

t

, )}, as a function of two variables. When

plotted, we obtain a surface. If the B-S model is correct, then the surface must be at, as

1.1. THE BLACK-SCHOLES FORMULA AND VOLATILITY SMILES 3

shown in Figure 1.1. This was indeed the case before the Black Monday of 1987 (October

19).

Figure 1.1 A at implied Blacks volatility surface

Figure 1.2 shows an implied volatility curve for S&P500 index option before 1987.

Figure 1.2 Representative S&P 500 implied volatilities prior to 1987.

Data taken from M. Rubinstein, Implied Binomial Trees J. of Finance, 69 (1994) pp. 771-818

The at volatility curve or surface are consistent with the lognormal assumption of the

asset dynamics. However, after the Black Monday, the pattern has changed substantially,

making the assumption lognormality awed.

4 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

1.2 The Reality in Todays Option Markets

The notion of volatility smiles means the smile-shaped curve of implied Blacks volatilities

of call or put options against their strikes (In a reasonably liquid market, call and put

options with identical strike should have identical implied volatility, as is mandated by the

call-put parity). Volatility smiles became a serious existence soon after the Black Monday

Crash of 1987. Most likely due to the crash ophopia and the increased demand for

out-of-the money put options as portfolio hedging instruments. Today, the smiles have

become a stylized feature in various derivative markets, including equity, interest-rate,

credit, forex, and even the ination market, although they may smile in some different

way.

Next, we demonstrate, for various markets, the typical patterns of volatility smiles or

skews.

1.2.1 Evidences of smiles in various market

Figure 1.3 Representative S&P 500 implied volatilities after 1987.

1.2. THE REALITY IN TODAYS OPTION MARKETS 5

Figure 1.4 The volatility surface according to S&P options markets.

Figure 1.5 The implied volatility surface for interest-rate caps

6 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

Figure 1.6 Implied volatility smile for USD/EUR on 17Dec01

Figure 1.7 Implied volatility smile for USD/JPY on 17Dec01

1.2. THE REALITY IN TODAYS OPTION MARKETS 7

Figure 1.8 Implied volatility smile for ination caps/oors on 4Sep08

1.2.2 Characteristic of Equity Implied Volatility Smiles

The characteristics of volatility smiles in equity derivatives is summarized in Derman

(2009).

1. Volatilities are steepest for small expiration as a function of strike, shallower for

longer expirations.

2. The minimal volatility as a function of strike occurs near ATM strike or ATM strike

for the forward price.

3. The volatility of implied volatility is greatest for short maturities, as with Treasury

rates.

4. There is a negative correlation between implied ATM volatility and the underlying

asset ( for DAX).

5. Implied volatility appears to be mean reverting with a life of about 60 days.

6. Implied volatility tends to rise fast and decline slowly.

7. Shocks across the implied vol surface are highly correlated.

The fourth characteristic is labeled as Leverage effect by Fisher Black (1976). Sup-

pose that the rm value follows a lognormal diffusion process, Black observed that the

8 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

volatility of the rms equity price will be a decreasing function of the equity price. To see

this, we start from the relationship

Firm value= Stock price + Liability.

Let A, B and S denote the rmvalue, the liability and equity price of the rm, respectively,

then there are

S = A B,

dA

A

=

A

dW

t

,

dS

S

=

dA

S

=

A

A

dW

t

S

=

_

1 +

B

S

_

A

dW

t

,

=

S

=

A

_

1 +

B

S

_

.

So, under the Blacks model for rm value, equity volatility decreases when equity price

increases.

1.2.3 Why Do Volatility Smiles Arise?

Idealized assumptions of the Black-Scholes (BS) Model.

The fair price of deep OTM or deep ITM options is more expensive than would be

assumed by the BS formulation.

By increasing prices for such options, volatility smile could be the markets indi-

rect way of achieving such higher prices within the imperfect framework of the BS

model.

In equity markets, volatility skew could reect investors fear of market crashes

which would cause them to bid up the prices of options at strikes below current

market levels.

Volatility smiles also reect supply and demand as well as risk premium paid to the

options.

As we have already seen, volatility smiles have become a stylized feature in derivatives

markets of various assets. If a production model cannot accommodation the smiles, there

will be consequences in pricing and hedging of other derivatives.

1. Pricing of Exotic Derivatives

1.2. THE REALITY IN TODAYS OPTION MARKETS 9

Using the BS model effectively means that for each option, a new IV must be

used, and therefore each option is priced using a different model (i.e., different

underlying distribution).

This is not an issue for the vanilla market options, like caps/oors and swap-

tions, because this is just a model to allow price quoting through volatility.

However, a problem arises when pricing structured derivatives because it is

no longer clear which of these models should be used, and in general, none of

these are suitable.

Suppose that we need to price an exotic option, say down-and-out call option,

with strike and knock-out barrier at . Which IV should we use, the IV at the call

strike or the IV at the barrier ?

Clearly, this option cannot be priced without a single, self-consistent, model

that works for all strikes without adjustment.

2. Hedging large book of options

Traders arent interested only in static volatility surfaces. They also want to

know how smile will respond to the time-to-maturity and changes in the un-

derlyings value.

Since different models are being used for different strikes, it is not clear that

delta and vega risks calculated at one strike are consistent with the same risks

calculated at other strikes.

For example, suppose that an option book is long strike options with a total delta risk of

$1M, and is long how strike options with a delta risk of -$1M. Is our book delta neutral?

Not really as it may leave residual delta risk that needs to be hedged due to using different

model for each strike.

1.2.4 The Mechanism for Volatility Smiles

There are strong evidences that the Black-Scholes world is too much an idealized de-

scription of the nancial markets, and the geometric Brownian motion (GBM) is a too

idealized description of asset-price dynamics. Let us use the S&P 500 time series data to

10 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

make the points.

Figure 1.9 SPX daily log return from 31Dec1984 to 31Dec2004

Figure 1.10 Frequency distribution of (77 years of )SPX daily log return compared

with normal distributions, where the -23% return on October 19, 1987 is not visible.

1.2. THE REALITY IN TODAYS OPTION MARKETS 11

Figure 1.11 Q-Q plot of the SPX log daily return compared with normal distribution.

Note the extreme tails.

Figure 1.12 The three-month ATM IV of DAX index option.

12 CHAPTER 1. INTRODUCTION TO VOLATILITY SMILES

Figure 1.13 SPX index v.s. three-month ATM IV of SPX options

Based on the previous plots we can make a few points.

1. The normal distribution underestimates the risks of big moves, practically the risk

of big drawdown.

2. Returns are not only always continuous, jumps in prices are possible.

3. The return distribution has the leptokurtic feature, the peak is higher and the tails

are fatter.

4. The implied volatilities can also jump.

If we add additional sources of risks, namely, stochastic volatilities and jumps, will the

price of the options become more accurate qualitatively or quantitatively? The answer is

positive. This has motivated a wave of researches.

Nonetheless, adding either stochastic volatilities or jumps make the market incom-

plete, in the sense that the additional risks cannot be hedged off, and risk premiums enter

pricing. In the early days, traders and quarts, who have been living in a fantasy world,

disdain that, and want to stay in a complete market. Dupire provided a desired solution

- the local volatility model. The local volatility models allow consistent pricing of exotic

derivatives, and it has a close relationship with the stochastic volatility models.

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