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Investment Banking

**A new approach to volatility skew
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Osaka University, 1 December 2005

Financial & Economic Research Center Nomura Securities Co., Ltd.

Toshinao AKUZAWA

This report represents only the personal opinion of the author.

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**Outline of this talk
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I. II. III. IV. Overview of local volatility models Markov-functional model for interest rate derivatives Markov-functional skew model Discussion and numerical results

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9 1.2 maturity Log-normal diffusion with space invariant volatility does not explain volatility skew. market IV varies with strike.volatility surface a map from strike and maturity to market implied volatility (IV) of European call/put option Typically. (volatility skew / smile) typical volatility of Nikkei 225 20% 19% 18% 17% 16% volatility 15% 14% 13% 12% 11% 80% 85% 10% 0. strike 3 .1 1.4 90% 95% 100% 105% 110% 115% 120% 0.

note on volatility surface Usually. a limited number of market prices is available. 4 . Many LV models require a complete information of volatility surface. A naive application of linear or spline interpolation may lead to a surface with arbitrage opportunity. We can apply Fengler’s method to construct an arbitrage-free volatility surface which uses smoothing spline.

(B ): standard Brownian motion under risk .Stochastic volatility (SV) models examples Heston model dSt = (rt − q)dt + Vt dBt1 St dVt = −λ (Vt − v )dt + η Vt dBt2 1 t 2 t (B ).neutral measure d Bt1 . Bt2 = ρdt Heston model with jump in stock price Heston model with jump in stock price and variance described by a small number of parameters perfect fit to volatility surface is impossible requires two factors (price and volatility) 5 .

t )dBt St (Bt )t ≥0 : standard Brownian motion under risk .Local volatility (LV) models Based on one factor model with local volatility dSt = (rt − q )dt + σ (St .neutral measure advantage? Sufficient degrees of freedom for perfect fit to volatility surface requires a complete volatility surface 6 .

Examples of local volatility models continuous theory Dupire discrete (lattice-based) models Derman et al. trinomial tree model drawback: Poor fit to volatility surface when volatility changes significantly with strike or maturity Andersen and Brotherton-Ratclie • semi-implicit and implicit scheme for PDE • unconditionally stable 7 . • binomial tree.

Consequently. method ADI hopscotch line hopscotch Strang symmetrization orthogonalization necessary necessary not necessary not necessary 8 . Orthogonalization in the two-factor case is impossible by its construction.consideration on existing LV models Deeply dependent on the numerical method for solving FDM The Computational cost of LV models is smaller than SV models. the ADI method is not available.

Markov-functional (MF) interest rate model one-factor interest rate model perfect fit to term structure can fit to some of swaption IVs 9 .

K –independence is postulated here.Ti an example of swaption volatility 60% 50% 40% 30% σ ( i . 20% 10% 0% 2 5 10 1 7 3 4 1 X 30 Y 0 10 .swaption Option to enter into Y-year interest rate swap at a specified date in the future (X) at a specified fixed rate (K) We assume that IV for a swaption with X = Ti Y = TN+1 . N +1) (t ) is available.

F TN +1 t ≥0 ) F TN +1 : forward measure. L . 11 .notation forward swap rates Yt ( i . Ti + 2 . N +1) Ti ⎧ ⎨ ⎩Ti +1 . N +1) = j =i +1 ∑ (T N +1 j − T j −1 ) Dti .T j { discount bond valuation date : t In this talk. TN +1 start date payment dates present value of a basis point (PVBP) of a swap Pt ( i . we choose a numeraire pair ((D ) tTN +1 .

N +1) ( ) = j =i +1 ( i . PTi YTi ( i .TN +1 = d ( i . N +1) X Ti .framework of MF interest rate model A hidden process. d ( i . ( X t )t ≥0 : standard Brownian motion under F TN +1 . N +1) X Ti . N +1) : R → R + and y ( i . ( ) = y (i . 12 . N +1) : R → R + is some monotone function which is not specified as of now. explains everything: DTi . N +1) : R → R + . N +1) X Ti ( ) where p ( i .T j = p ( i . N +1) ∑ (T N +1 j − T j −1 )DTi .

outline of MF interest rate model “calibration” 1. forward swap rates. construct a space-time lattice for X 2. 13 . (No numerical difficulty in solving PDE) •we can evaluate LIBORs. forward LIBORs. valuation of a claim on interest rate is straightforward since •the governing SDE is very simple. and others on each node by using the numeraire. swap rates. determine the value of the numeraire at each node by backward induction Once the numeraire at each node is obtained.

N +1) DTi . N +1) DTi . N +1) and DTi+1 . N +1) .TN +1 yTi ( i . N +1) are known on each node at Ti+1 .backward induction step 1 Suppose that the values of step 3 Determine PTi+1 ( i +1. we can readily decide step 2 Evaluate numeraire-rebased PVBP at Ti PTi ( i . YTi+1 ( i +1. step 4 Using the result of step 2 and 3.TN +1 and PTi ( i .TN +1 . 14 .TN +1 by simply applying the time propagation operator to PTi+1 ( i . DTi+1 . N +1) . on each node at Ti by using swaption IVs and numeraire-rebased PVBP.

digital swaption (Step 3 in detail) digital swaption with strike K and maturity Ti pays PVBP when swap rate is higher than K ( i .N+1)(K. N +1) payoff : 1y ( i . Ti ) the PV of this digital swaption at t. N +1 ) Ti PTi ≥K We denote by V(i. 15 .

N +1) ≥ K yt yt ( i . N +1) 2 (Ti − t ) / 2 ⎥ −σ ⎢ ln V (i . t ) = E ⎢ yTi ≥ K i V ( i . it is identical to the IV of digital swaption.N +1) PT (i . N +1) ⎤ ( i . It follows expression of digital swaption PV in terms of swaption volatility: ⎡ yt (i .N +1) ⎡1y ( i . N +1) If swaption volatility is independent of K. N +1 ) ( i . N +1) ⎤ = E S ( i . N +1) S ⎢ Ti ⎥ ⎥ ⎢ ⎣ ⎦ Pt PTi ⎦ ⎣ ( i . t ) K = Φ⎢ ⎥ ( i . N +1) ( i .digital swaption PV in terms of swaption IVs (Step 3 in detail) PV formula of digital swaption under swaption measure: ⎤ ⎡1 ( i . N +1) ( i . N +1) (K . N +1) ⎥ ( i . N +1) (K . N +1) Pt (Ti − t ) σ ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ( ) 16 .

N +1) )−1 (K ) Ak . we can readily evaluate the RHS. 17 .PV of digital swaption from hidden process (Step 3 in detail) PV formula of digital swaption under forward measure: ⎤ ⎡1 ( i . to node (k .TN +1 k∈{space index of Ti . t ) = E ⎢ yTi ≥ K i V ( i . N +1) ⎥ yt F TN +1 ⎢ ⎥ Dt .TN +1 DTi . N +1) It follows PTi V (i .i : arrival prob. N +1) ( ) (K ) −1 is given. N +1) (K .TN +1 i ( i .N +1) PT ( i . t ) = ∑ nodes at T }1xi ≥(y (i .TN +1 ⎦ ⎣ ( i . N +1) (K . N +1) Ak .i D Dt . i ) If z = y ( i .

i) ) By comparing these formulae. we have two digital swaption PV formulae digital swaption value when strike is given in y-space coordinate digital swaption value when strike is given in X-space coordinate K = y ( i . 18 .two formulae for digital swaption (Step 3 in detail) Now. N +1) (x j .i ) (x j .N+1). we can determine the functional form of y(i.i : value of X at node (j .

We can use swaption volatility as IV of digital swaption. A backward induction is required.summary of MF interest rate model A hidden process with a very simple SDE explains the In the example above. 19 . we choose whole world: discount curve some of swaption volatilities swaptions with X+Y=Ti-t.

numerical example caplet-based MF model 50% 45% 40% market IV MF value minus Market IV 35% 30% 25% 5% 4% 3% 2% 1% 0% -1% 20% 15% 10% 5% 0% 1 3 X 5 10 1 2 3 4 5 7 10 20 Y swaption PV by MF model 50% -2% 1 3 X 5 10 1 2 3 4 5 7 10 20 Y 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1 3 X 5 10 1 2 3 4 5 7 10 20 Y 20 .

21 . t ) Here. monotone function s : R2 → R+ is yet to be specified. (St).MF skew model A hidden process ( X t )t ≥0 : standard Brownian motion under risk . We consider equity options on a single stock price.neutral measure Q explains everything as before: St = s( X t .

construct a time-space lattice for X 2. determine function s using IV for call / put options for each node We use two formulae for digital call option with payoff : 1ST ≥ K i Once stock price attached to each node is obtained.outline of MF skew model “calibration” 1. 22 . any claim on stock price is evaluated straightforwardly.

σ . 23 . σ (K . t ) = ln κ + r − q + (γ − 0.5)σ σ t { 2 } ∂ (ST − K )+ = −1ST ≥ K ∂K and φ ( x) = dΦ ( x ) : density function of normal dist. Ti ) ( r − q )(T −t ) − e St Ti − tφ (D (1) (St / K . IV of digital call with strike K ≠ IV of call option with strike K ≡ σ ( K .forward value of digital call in terms of IV Partial derivative of BS formula for call option: F ( K . Ti ). dx Note: When skew is present. Ti − t )) ∂σ (K . Ti − t )) i (1A) ∂K where D (γ ) (κ . Ti ) = Φ (D ( 0 ) (St / K . σ (K . Ti ) . Ti ).

F ( K . we have ⎛ −z ⎞ ⎟. Then. Ti ) = Φ⎜ ⎜ T −t ⎟ ⎝ i ⎠ (1B) 24 .forward value of digital call from hidden process Strike K corresponds to some z in X-space by K = s ( z ) or z = s −1 ( K ).

Now. we have two digital call forward value formulae digital call forward value when strike is given in S-space coordinate (1A) digital call forward value when strike is given in X-space coordinate (1B) By comparing these formulae. we can determine s as in the case of the MF interest-rate model： Use (1B) to evaluate digital call with z = xji determine K = Kji which reproduces the digital call value at z = xji by (1A) K ji = s (X ji ) 25 . (1A) and (1B).

1.summary of MF skew model A hidden process with a very simple SDE explains the whole world: stock price entire volatility surface provided the surface is arbitrage-free No backward induction is required for calibration. where backward induction is necessary as in the MF interest rate model without skew.2.) are determined independently... Stock prices attached to the nodes at each Ti (i=0.. Note We can also construct MF skew model for interest rate. 26 .

we can try advanced FDM methods which are • faster than Crank-Nicholson. Fit to the volatility surface easy to decorrelate in the two-factor cases 27 .advantage of MF skew model (among local volatility models) numerical stability Stability depends on the FDM method. So. any FDM method is supposed to handle standard Brownian motion properly. • but is difficult to handle. But.

j −1 f n +1 = Bi . j f n + Bi . j +1 f n + Bi . j −1 f n 1444444444444 2444444444444 3 4 4 5 degrees of freedom with coefficients of f n+1 and f n 28 . j +1 f n +1 + Ai . j f n +1 + Ai .an example of advanced FDM method Smith’s optimal / near-optimal scheme makes full use of five degrees of freedom within 3-point approximation: Af n +1 = Bf n j +1 A. B : tridiagonal j j −1 j +1 j j −1 Ai .

1% error IV MF skew (Smith) MF skew (Crank-Nicholson) market IV error: MF skew (Smith)-market IV error: MF skew (Crank-Nicholson)-market IV 0.numerical example 100x100 lattice 200 days to maturity 50% 45% 40% 0.0% 10% 5% 0% 60% 70% 80% 90% 100% strike 110% 120% 130% -0.3% 29 .1% 140% 0.2% 35% 30% 25% 20% 15% 0.

3% 30 .0% IV 0.1% error MF skew (Smith) MF skew (Crank-Nicholson) market IV error: MF skew (Smith)-market IV error: MF skew (Crank-Nicholson)-market IV 0.numerical example 100x100 lattice 200 days to maturity 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 60% 70% 80% 90% 100% strike 110% 120% 130% -0.1% 0.2% 0.2% 140% -0.

extension to two-factor model When we introduce a second factor with dYt = ν t dt + σ (t )dBt B : standard Brownian motion under the risk .neutral measure d B. 2 2 ⎟ ⎜ ∂t 2 ∂x ∂x∂y 2 ∂y ∂y ⎠ ⎝ which is easily orthogonalized. 31 . X t = ρ (t )dt the PDE to solve is ⎞ ⎛ ∂ 1 ∂2 σ 2 ∂2 ∂2 ∂ ⎜ + + ρσ + +ν − r ⎟ f = 0.

justifying local volatility models two ways to determine delta Sticky-moneyness rule assumes the parallel shift of volatility surface when stock price moves Sticky-implied tree rule local volatility function (from stock price to local volatility) remains fixed even if stock price changes. Matytsin (2000) delta by stick-implied tree rule ≈ hedge ratio which minimizes PL variance under the assumptions: •SV model •portfolio is composed of stock and option (incomplete market setting) We have only one hedge tool (= stock) quite often. 32 .

LV value + LV delta Determine IV by Heston 33 . SV value + SV delta 2. LV value + SV delta 4.hedge simulation generate Paths by Heston Determine premium and delta by MF skew model (LV) and Heston model (SV) hedge simulation: 1. SV value + LV delta 3.

maturity = 6 months) daily rebalancing from date of issue to maturity: t = (0.simulation setting Up and Out call (strike = 100 .0 Vol of Variance = 80% Correlation = -0. barrier = 110.3) S0 = 100 Initial volatility surface Heston Parameters Initial Vol = Long Term Vol = 30% Mean Reversion =4.5Y 1Y 2Y Strike 105% 2M 3M 6M 120% 9M 5% 3 0% Maturity 34 .5% 40% 35% 30% 25% 20% 15% 10% 75% 90% 1.

90 variance of strategy 0 < variance of strategy 1 0.00 0.11 1.75 1.66 0.53 1.87 1. of strategy 0 SV value + SV delta SV value + LV delta LV value + SV delta LV value + LV delta SV value + SV delta SV value + LV delta LV value + SV delta LV value + LV delta 1.00 1.comparison of PL variances 500 trials A rough test for equality of variance is performed.33 0.00 35 .15 variance of strategy 0 > variance of strategy 1 strategy 1 1.28 1.78 0. (F-test: Significance level : 5%) strategy 0 var. of strategy 1 / var.00 1.19 0.84 1.

Our model captures market volatility structure very accurately and is stable irrespective of the numerical scheme for solving PDEs. 36 . Orthogonalization in space direction and time propagation by the ADI scheme is straightforward for a wide class of problems.summary A simple. yet useful new local volatility model is constructed which is motivated by the MF interest rate model.

Arbitrage-free smoothing of the implied volatility surface. Brotherton-Ratcliffe. I. preprint (2005) 37 . and A. Part1: constant coefficient 1-D. http://www. Finance and Stochastics 4. (2000). 391–408 (2000). R.References E. Trans. Kennedy.ca/groupefinance/activites/fichiersfinance/matytsin. L. Fengler. Tech. 455.qc. Implied Trinomial Trees of the Volatility Smile. P. Chriss. Soc.pdf .cirano. Lond. Goldman Sachs (1996). J. Derman.. 5–38 (1997). Pelsser. Matytsin. Merril Lynch. Smith. and N. Markov-Functional Interest Rate Models. Optimal and near-optimal advection-diffusion finite-difference schemes. A. Stochastic Volatility and Jump Diffusion In Equity Markets. Phil. Kani. rep. The equity option volatility smile: An implicit finite difference approach. R. 2371–2387 (1999). Journal of Computational Finance 1. Hunt. Andersen and R. R.

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