How much is a smile worth in an exotic world

of equity derivatives?
Theodor Munteanu
30 September 2020

Contents
1 Abstract 2

2 Introduction 2

3 Pricing exotic derivatives that are not path-dependent 4

3.1 Intro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 Choosing the right universe of options . . . . . . . . . . . . . 4
3.3 Q1: Pricing and its methodologies . . . . . . . . . . . . . . . . 6
3.4 Q2: Replication & hedging . . . . . . . . . . . . . . . . . . . . 12
3.5 Q3: Sensitivities. . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.6 Using risk neutral distribution in pricing, P&L study and
breakeven analysis . . . . . . . . . . . . . . . . . . . . . . . . 14
3.7 Further examples of exotic pricing . . . . . . . . . . . . . . . . 16

4 Path-dependent valuation of options 16

4.1 Using the volatility term structure and local volatility models 16
4.2 Monte Carlo implementation. Using control variates . . . . . . 16

5 Appendix 16
5.1 Implied distribution and volatiltiy surface from market prices . 16
5.2 Option greeks under volatility smile . . . . . . . . . . . . . . . 17
5.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18