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The 2D PDE for the price

Conclusion and perspectives

Local volatility surfaces for illiquid currency pairs

Gabriel Turinici, Marc Laillat

Universite Paris Dauphine and Adn Analytics, Thomson Reuters

Conference on Numerical Methods in Finance, Paris-ENPC,

Apr. 17th, 2009

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

1D Black-Scholes PDE

The 2D PDE for the price

Outline

1

Motivation: illiquid cross currency options

1D Black-Scholes PDE

The 2D PDE for the price

2

Local volatility calibration: choice of variables

Algorithm

Results

3

The 2D PDE for the price

Dirichlet boundary conditions

Using a Dupire style equation

4

Conclusion and perspectives

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

1D Black-Scholes PDE

The 2D PDE for the price

Illiquid cross currency options

In practice we know the price of many FOREX options for major

currency pairs: EUR/USD, JPY/USD, GBP/USD, EUR/GBP, etc.

What about a rm wanting to hedge the risk of Japan yen (JPY)

versus e.g., New Zeeland $ (NZD) ?

They need an JPY/NZD option but only available are

S

1

= JPY/USD and S

2

= NZD/USD. What is the price of a

cross-currency JPY/NZD option ?

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

1D Black-Scholes PDE

The 2D PDE for the price

Price of a call option: 1D Black& Scholes PDE

Suppose NZD/JPY cross-rate S

t

follows the SDE

dS

t

/S

t

= (r q)dt + dW

t

(1)

Here r = interest rate for the rst currency (JPY), q= interest rate

for the second currency (NZD), =

JPY/NZD

is the volatility.

The price C follows the Black-Scholes PDE

t

C + (r q)S

S

C +

2

S

2

2

SS

C rC = 0 (2)

C(S, t = T) = (S

T

K)

+

. (3)

Price today is C(S

0

, t = 0).

JPY/NZD

is unknown and there are no /few options quoted (no or

illiquid market).

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

1D Black-Scholes PDE

The 2D PDE for the price

Price of cross-currency options: 2D Black-Scholes

t

c + S

1

S

1

c + S

2

S

2

c +

+

2

1

(S

1

)

2

2

S

1

S

1

c +

2

2

(S

2

)

2

2

S

2

S

2

c +

1,2

S

1

S

2

2

c

S

1

S

2

rc = 0 (4)

c(T, S

1

, S

2

) = S

2

[S

1

/S

2

K]

+

= [S

1

KS

2

]

+

. (5)

1

= r r

1

,

2

= r r

2

, r ,

1,2

are known.

Rq: if

1,2

is not known then procedure can be see as calibration of

it when c is known.

Rq: outperformer option = particular case, payo [S

1

S

2

]

+

.

More generally pair trading.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

1D Black-Scholes PDE

The 2D PDE for the price

Price of cross-currency options: 2D Black-Scholes

Rq:

1

,

2

= constant then S = S

1

/S

2

follows the dynamics

dS

t

/S

t

= (r q)dt + dW

t

(6)

with =

_

2

1

+

2

2

2

1

2

thus one has result by Black&

Scholes analytic formula

To do :

local volatility calibration problem from quoted option prices

(on S

1

and S

2

) obtain the surfaces

1

and

2

solve the 2D PDE

Rq: also possible by Monte-Carlo, should get same result.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Outline

1

Motivation: illiquid cross currency options

1D Black-Scholes PDE

The 2D PDE for the price

2

Local volatility calibration: choice of variables

Algorithm

Results

3

The 2D PDE for the price

Dirichlet boundary conditions

Using a Dupire style equation

4

Conclusion and perspectives

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Local volatility calibration: choice of variables

Calibration: we have several prices quoted for dierent strikes K

and maturities T

: C

market

K

,T

such that C(S

0

, t = 0; K

, r , T

, (S, t)) = C

market

K

,T

for all .

t

C

+ (r q)S

S

C

+

2

S

2

2

SS

C

rC

= 0 (7)

C

(S, T

) = (S K

)

+

(8)

Procedure: automatic (because only an intermediary product) i.e.

results robust with respect to user parameters, numerically stable

w/r to input (even for hard cases e.g. JPY/USD), (fast), precise

(< 0.1% in implied vol).

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Calibration: what variables to chose

Existing literature: all invert the mapping C.

Coleman et Li, Verma: parametric setting

L. Jiang et al., Achdou & Pirroneau : control framework

(adjoints)

Lagnado et al. : constraints

Consider the mapping local to implied instantaneous variance

v =

2

V(v) = w = (

I

)

2

1

asymptotics: if lim

S0/

v(S, t) = v

/+

(t) then

lim

S0/

V(v)(S, t) =

1

t

_

t

0

v

/+

(s)ds, i.e. mapping is

LINEAR

2

for = (t) one can also prove numerical stability properties

Idea: use this mapping for inversion.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Calibration: general penalization result

Theorem

Let H be a Hilbert (Banach) space and T : H R weakly

continuous with inf

vH

T(v) > (lower bounded). Denote

J

e

:= v

2

H

+ T(v). Then

1

the minimization problem inf

vH

J

solution v

2

one of the following alternatives is true

1 lim

0

v

H

= and in this situation inf

vH

T(v) has no

minimizer in H.

2 v

H

is bounded and in this case inf

vH

T(v) has at least one

solution on H. Moreover any limit point for 0 of the

sequence (v

min

T()=min

vH

T(v)

H

. (9)

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Calibration: local to implied mapping

minimize the functional

J

(v) = v

2

L

2

+

L

=1

(V(v)(K

, T

) V(v

0

)(K

, T

))

2

(10)

Sequentially Quadratic Problem (SQP) (+ regularization,

constraints)

min

p

_

J

(v

k

)+D

v

J

(v

k

)(p)+

1

2

D

vv

J

(v

k

)(p, p)

v

k

+p K

_

(11)

Then one sets v

k+1

= v

k

+ p

k

(p

k

is the solution of the QP).

Gauss-Newton style approximation for each QP: only need D

v

V(v).

Rq: dumb projected gradient algorithm is also OK ... thus the

variables are important.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Calibration: optimization algorithm

D

v

V(v)(K

, T

) = 2

_

V(v)(K

, T

)

1

I

l ,BS

D

v

C

. (12)

D

v

C

(S

0

, 0) =

S

2

2

(

SS

C

). (13)

For D

v

C use an adjoint ( Fokker-Planck)

t

+

S

((r q)S)

SS

(

vS

2

2

) + r = 0 (14)

(S, t = 0) =

S=S

0

. (15)

Rq.: only used in a weak sense thus numerics ok.

Expansion in a basis

v(S, t) =

ij

f

ij

(S, t). (16)

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Figure: Shape form.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Figure: Benchmark from Andersen et al., Coleman et al. for S&P 500

options.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Figure: Implied volatility surface for JPY/USD options dated March 18th

2008, courtesy of Thomson Reuters Financial Software.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Figure: Local volatility surface for JPY/USD options dated March 18th

2008, courtesy of Thomson Reuters Financial Software.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Algorithm

Results

Figure: Local volatility surface for the South African Rand (ZAR) vs.

USD options Nov. 2008, courtesy of Thomson Reuters Financial

Software.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Dirichlet boundary conditions

Using a Dupire style equation

Outline

1

Motivation: illiquid cross currency options

1D Black-Scholes PDE

The 2D PDE for the price

2

Local volatility calibration: choice of variables

Algorithm

Results

3

The 2D PDE for the price

Dirichlet boundary conditions

Using a Dupire style equation

4

Conclusion and perspectives

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Dirichlet boundary conditions

Using a Dupire style equation

The 2D PDE for the price: Dirichlet boundary conditions

Price of a cross-currency option follows the 2D PDE:

t

c + S

1

S

1

c + S

2

S

2

c +

+

2

1

(S

1

)

2

2

S

1

S

1

c +

2

2

(S

2

)

2

2

S

2

S

2

c +

1,2

S

1

S

2

2

c

S

1

S

2

rc = 0 (17)

c(T, S

1

, S

2

) = S

2

[S

1

/S

2

K]

+

= [S

1

KS

2

]

+

. (18)

Yet to chose : the boundary conditions: we use Dirichet ...

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Dirichlet boundary conditions

Using a Dupire style equation

The 2D PDE for the price: boundary conditions

(green) S

1

/S

2

<< K: c(t, S

1

, S

2

) = 0;

(blue) S

1

/S

2

>> K: use put-call parity

c(t, S

1

, S

2

) = S

1

e

r

1

(Tt)

KS

2

e

r

2

(Tt)

(red) S

1

, S

2

both small/large :

1

,

2

are undetermined: we

take them constant and use the explicit Black-Scholes formula

Figure: The domain in S

1

/S

2

.

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Dirichlet boundary conditions

Using a Dupire style equation

Using a Dupire style equation

When prices are to be computed for many K, T one can use a

Dupire / Kolmogorov eqn. as in A. Conze, N. Lantos, O. Pironneau

Comm. Pure & Appl. Anal.(CPAA) 8(1), 195-208, 2009. For

t

P +

2

k=1

S

k

_

S

k

k

P

_

S

k

S

k

_

2

k

S

2

k

2

P

_

2

S

1

S

2

_

1,2

S

1

S

2

2

P

_

+ rP = 0 (19)

P(t = 0, S

1

, S

2

) =

S

1

=S

market,t=0

1

,S

2

=S

market,t=0

2

. (20)

BC: Dirichlet, zero for S

1

, S

2

far from initial values.

Then price is

_

R

2

+

P(T, S

1

, S

2

)(S

1

KS

2

)

+

dS

1

dS

2

.

Advantage: one PDE enough for all K, T (as Dupire). BUT: need

to solve a PDE with initial data a Dirac mass (use numerical

adjoint ).

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Outline

1

Motivation: illiquid cross currency options

1D Black-Scholes PDE

The 2D PDE for the price

2

Local volatility calibration: choice of variables

Algorithm

Results

3

The 2D PDE for the price

Dirichlet boundary conditions

Using a Dupire style equation

4

Conclusion and perspectives

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

The 2D PDE for the price

Conclusion and perspectives

Conclusion and perspectives

procedure tested on simple cases and approximations are ok;

future implementation w. Thomson Reuters under study.

further stability properties: techniques exist that render an

unique solution to the inverse pb.

Refs: preprints: scholar google search Gabriel Turinici

calibration and http://hal.archives-ouvertes.fr;

calibration local implied var.: to appear in J. Comp. Fi. (2009)

Acknowledgements : collaborators: Mohammed Aissaoui, Kalide

Brassier, Arthur Pham (Adn team of Thomson Reuters) ;

discussions: O. Pironneau (University Pierre et Marie Curie, Paris)

Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs

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