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Time to smile

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 Option pricing l Cutting edge

Time to smile
Vladimir Piterbarg derives ‘effective’ time-independent parameters for stochastic volatility
models with time-dependent coefficients. These formulas facilitate efficient calibration of
time-dependent stochastic volatility models to market prices of European-style options with
different strikes and expiries

E
fficient numerical methods for stochastic volatility models are typi-
cally available only for models with constant coefficients (see An-
dersen & Brotherton-Radcliffe, 2001, Hagan et al, 2002, Zhou, 2003,
and Andersen & Andreasen, 2002). For a model with time-dependent pa-
rameters, one usually needs to resort to time-consuming numerical algo-
able (see Andersen & Andreasen, 2002). Instead of deriving approxima-
tions for European-style options in the model (1), (2) directly, we seek to
find ‘effective’ (constant) volatility, skew and volatility of variance λ, b and
η such that the term distribution of _ S(T) that follows (1), (2) is approxi-
mated by the term distribution of S (T) defined by the stochastic differen-

ia
rithms such as partial differential equations (PDEs) or Monte Carlo to price tial equations (SDEs):
even the simplest European-style options. This makes calibration of such d z (t ) = θ ( z0 − z (t )) dt + η z (t )dV (t )

ed
(3)
models to European-style options impractical. However, the need to relax
the assumption of time-stationarity is real and serious, as models with con-
(
dS (t ) = λ bS (t ) + (1 − b) S (0) ) z (t )dU (t ) (4)

stant coefficients are generally incapable of fitting market prices across op-
tion expiries. Calibration to options of multiple expiries is required for
consistency if exotics are to be priced. This is so because exotics do not
only depend on the distribution of the underlying at a particular point in
time, but on its dynamics through time.
In this article, we solve the problem of European-style option calibra-
si
tion for stochastic volatility models with time-dependent parameters. To
ci
M
This approach of ‘parameter averaging’ has significant advantages for cal-
ibration. Market implied ‘term’ stochastic volatility parameters λ, b, η are
ve
typically already maintained by vanilla options trading desks for different
expiries. Deriving σ(t), β(t), γ(t) from these parameters directly is numer-
ically much more efficient than calculating European-style option prices
first, and then solving non-linear optimisation problems to find σ(t), β(t),
γ(t). This is particularly important for such numerically demanding tasks

our knowledge, ours is the first effective method for doing so. We work
in the context of purely diffusive stochastic volatility models; in particular, as calibrating forward Libor models to volatility smiles across the whole
In

we do not consider jumps. This is left for future work. Adding jumps to a swaption grid.
model adds realism, and also somewhat alleviates the need for time-de-
pendent parameters; however, jumps cannot eliminate the need completely. ‘Effective’ volatility of variance
ht

This is especially true for applications to longer-dated exotics, such as long- The main effect that the volatility-of-variance parameter has on the implied
dated forex or equity barrier options. The calibration formulas we derive volatility smile is to change its curvature. The amount of curvature in the
ig

are based on the idea of ‘homogenisation’, or ‘parameter averaging’. In- smile is directly proportional to variance of realised volatility, which is de-
stead of seeking European-style option prices in the model with time-de- fined by:
yr

pendent parameters directly, we try to find a model with constant

∫0 σ (t ) z (t ) dt
T 2
parameters such that option prices between the two models match. This
op

approach has distinct numerical advantages for calibration (the main in- The effective volatility of variance η is derived from the requirement
tended application), of which more will be said later. that the curvature of the volatility smile in the model (1), (2) be the same
as in the model (3), (4). This leads to the following equation to be solved
C

Calibration by parameter averaging for η:

Let the stochastic variance process z(⋅) follow the square-root dynamics:
(∫ σ (t) z (t) dt) = E(∫ σ (t) z (t) dt)
T 2 T 2
2 2 (5)
dz (t ) = θ ( z0 − z (t )) dt + γ (t ) z (t )dV (t ) , z (0) = z0
E
(1) 0 0

where θ is the mean reversion of variance and γ(t) is the (time-dependent) By evaluating these expected values, the effective volatility of variance to
volatility-of-variance parameter. Let the underlying S(t) (which can be a maturity T can be shown to be equal to:
share price, a forward forex rate, a swap or Libor rate) follow the process:
∫ γ (t ) ρ(t ) dt
T
2

(
dS (t ) = σ (t ) β (t ) S (t ) + (1 − β (t )) S (0) ) z (t )dU (t ) (2) η
2
= 0 T (6)
The deterministic function σ(⋅) is the time-dependent volatility and β(⋅) is
∫0 ρ(t ) dt
the time-dependent skew function. With the slope of the implied volatili- where the weight function ρ(⋅) is given by:
ρ ( r ) = ∫r ds ∫s dtσ 2 (t ) σ 2 ( s ) e − θ(t − s)e −2θ( s − r )
ty smile in this model generated by the local volatility function1: T T

β (t ) x + (1 − β (t )) S (0)
the correlation between Brownian motions (whose primary effect on the
volatility smile is also to control the slope) can be set to zero2:
dV , dU = 0
In the next section, we derive the effective skew formula.
1 While a linear local volatility function is used for presentation, the method also works
for other local volatility function types that exhibit low curvature, such as constant
elasticity of variance
2 While the correlation between the driving Brownian motions dV and dU is zero, the

correlation between increments of the spot price and the implied at-the-money Black
For a model with constant parameters σ(t) and β(t), the model reduces to volatility is not, in accordance with empirically observed phenomena. The proof of this
the well-known displaced-diffusion stochastic volatility model, for which statement is beyond the scope of this article, but can be derived from the results of
efficient numerical methods for European-style option valuation are avail- Zhou (2003)

WWW.RISK.NET ● MAY 2005 RISK 71

Cutting edge l Option pricing

‘Effective’ skew where the weights w(⋅) are given by:

The ‘effective’ volatility of variance in the previous section is obtained as
v 2 (t ) σ 2 (t )
a time-weighted average of the volatility-of-variance function. In the Black- w (t ) =
∫0 v (t ) σ (t ) dt
T 2 2
Scholes model with time-dependent volatility, the ‘effective’, or term, volatil-
(11)
ity is also a time-weighted average of the time-dependent volatility function.
eθs − e − θs
v (t ) = ( s) ds + ( s)
t t
We seek a similar representation for the ‘effective’ skew. A formal and rig- 2
∫
z02 0 σ 2 z0 η2e − θt 0 σ 2
∫ ds
orous derivation based on asymptotic expansions is presented in Piterbarg 2θ
(2004); here, we give a more intuitive argument. Let us consider a simple example. Recall that β(t) is a slope of the local
Consider two diffusion processes, one with a time-dependent _ skew volatility function at time t. The ‘effective’ skew b is related to the slope of
function f (t, x) and the other with a time-independent one f (x): the implied volatility smile. So the slope of the term smile is equal to an av-
erage of instantaneous slopes, with weights w(t). Under the assumption of
dX (t ) = f (t , X (t )) z (t )σ (t ) dW (t ) , X (0) = x0 no stochastic volatility, η = 0, using scaling z0 = 1, and constant swaption
dY (t ) = f (Y (t )) z (t )σ (t ) dW (t ) , Y (0) = x0 volatility σ(t) ≡ σ, we obtain simple formulas for the ‘effective’ skew:
v 2 ( t ) = σ 2t
Without loss of generality:
f (t , x0 ) ≡ f ( x0 ) = 1
t t
w (t ) = T
=
∫0 t dt T2 /2
We argue that, to match prices
_ of options of all strikes between the two

ia
models, we need to find f *(x) such that: so that:
f * (⋅) = arg min {ρ ( X , Y )}

ed
1 T
f (⋅)
(7)
b= 2 ∫ tβ (t ) dt
T /2 0
ρ ( X , Y )
E ( X (T ) − Y (T ))
2

M
_ In the next section, we derive an effective volatility formula. We assume
Suppose f (⋅) is specified. Applying Itô’s lemma: that the volatility of variance and the skew have already been averaged.

_
T
( (
ρ ( X , Y ) = ∫0 E z (t ) f (t , X (t )) − f (Y (t )) ) ) σ 2 (t ) dt
2
ve
‘Effective’ volatility
The results obtained so far show how to approximate the SDE (2) with an
Expanding f(t, x), f (y) to the first order: SDE with a constant skew b:
si
ρ( X ,Y ) ≈ dS (t ) = σ (t ) (bS (t ) + (1 − b) S (0)) z (t )dU (t ) (12)
ci

  ∂ ∂ 
2
where z(⋅) follows a time-homogeneous SDE (3). The volatility function in
∫0 E  z (t )  ∂x f (t , x0 ) ( X (t ) − x0 ) − ∂x f ( x0 ) (Y (t ) − x0 )  σ (t ) dt
T 2
In

(12) is still time-dependent, and the SDE has not been completely reduced
 
to the form of (4). This step is taken next. Before proceeding, we note that
Further approximating: the exact valuation of European-style options, based on numerical Fouri-
ht

X (t ) − x0 ≈ X 0 (t ) − x0 er inversion of the solution to a system of ordinary differential equations,

is possible in the model (12), (3) (see Andersen & Andreasen, 2002). What
Y (t ) − x0 ≈ X 0 (t ) − x0
ig

we propose is much faster, although may not be quite as accurate.

where X0(t) is given by: The method is based on representing a European-style option price as
yr

an integral of a known function against the distribution of the term sto-

dX 0 (t ) = z (t )σ (t ) dW (t ) , X 0 (0) = x0
chastic variance. In particular, for an at-the-money (K = S0) call option:
op

(( ))
we obtain:
E ( S (T ) − S0 ) = E E ( S (T ) − S0 ) z (⋅)
+ +
(13)
( ) ) σ (t ) dt
T 2
⌠  ∂ ∂ 
ρ( X ,Y ) =  ( ) ( )
  ∂x f t , x0 − ∂x f x0  E z (t ) X 0 (t ) − x0 ( 2 2
C

⌡0 Because the Brownian motion that drives z(t) is independent of the Brown-
Solving the minimisation problem (7), we end up with the following ex- ian motion that drives S(t), the distribution of S(T) (in the model (12)) con-
pression on the effective skew: ditioned on a particular path {z(t)}Tt= 0 is a shifted lognormal. Hence, the
∂f * ( x0 ) ⌠ ∂f t , x0
T
( )w t inside condition expectation in (13) can be evaluated easily to yield:
= ( ) dt (8)
E ( S (T ) − S0 ) = Eg ( Z (T ))
+
∂x ⌡0 ∂x

Z (T ) = ∫0 σ 2 (t )z (t ) dt
T
where the weights w(t) are calculated according to the formula:

v 2 (t ) σ 2 (t )
w (t ) = where g is a known function:
(t ) σ 2 (t ) dt
T 2
∫ 0
v
(9)
S0
g ( x) = ( (
2Φ b x / 2 − 1 ) )
( )
b
v (t ) = E z (t ) ( X 0 (t ) − x0 )
2 2
Φ ( y ) = P (ξ < y ) (14)

Applying this result to the equation (2) (with z(⋅) following (3), the equa- ξ ∼ N (0,1)
tion with the averaged volatility of variance), the following result is ob- The problem of finding an ‘effective’ variance can then be represented
tained. The effective skew b for the equation: as finding such λ that:
(
dS (t ) = σ (t ) β (t ) S (t ) + (1 − β (t )) S (0) ) z (t )dU (t )
Eg (∫ σ (t) z (t) dt) = Eg (λ ∫
T 2 2 T
z (t ) dt ) (15)
0 0
over a time horizon [0, T] is given by:
Neither of the expected values on both sides of (15) is easy to calculate.
b = ∫0 β (t )w (t ) dt
T
(10)
The Laplace transform of ∫ T0 σ2(t)z(t)dt in the model (12) is, however, easy

72 RISK MAY 2005 ● WWW.RISK.NET

to calculate numerically (see Andersen & Andreasen, 2002, and the ap- A. Instantaneous and effective vol of variance
pendix for details). This observation suggests approximating g(x) with a
function of the form: Expiry (years) 0.02 1 2 3 4 5 6 7
g ( x) ≈ a + be − cx Instantaneous 75% 95% 113% 128% 142% 154% 166% 178%
vol of variance
We choose the coefficients a, b, c from the local second-order fit condi- Effective 75% 81% 87% 93% 99% 105% 111% 117%
tion around the mean of ∫ T0 σ2(t)z(t)dt: vol of variance

g (ζ) = a + be − cζ
g ′ (ζ) = −bce − cζ 1. Implied volatilities for the test of volatility
g ′′ (ζ) = bc e 2 − cζ of variance averaging
ζ = EZ (T ) = ∫0 σ 2 (t ) (Ez (t )) dt
T
(17)
20.5
= z0 ∫0 σ (t ) dt
T 2

Implied Black volatility (%)

20.0
These imply (only c is important for the derivation below) that:
g ′′ (ζ)

ia
c=− 19.5
(18)
g ′ (ζ)

ed
Having calculated the coefficients a, b, c, the problem (15) is approximated 19.0
with:
( ) ( ) 18.5

M
a + bE exp − c ∫0 σ 2 (t ) z (t ) dt = a + bE exp − cλ 2 ∫0 z (t ) dt
T T
7y
(19) 5y

iry
( ) ( ) 18.0 3y

Exp
E exp = − c ∫0 σ 2 (t ) z (t ) dt = Eexp − cλ 2 ∫0 z (t ) dt
T T
ve 80 1y
85 90 95 100 105 110 115 120
These considerations define the effective volatility approximation. If we Strike
denote the Laplace transform of Z(T) by:
si
ϕ (µ )
Eexp ( − µZ (T ))
ci

B. Approximation error in the test of volatility

and the Laplace transform of the integral of z(t) by: of variance averaging
In

(
ϕ 0 (µ )
Eexp − µ ∫0 z (t ) dt
T
) Strike
Expiry 1y
80
2.60
85
1.26
90 95 100 105
0.26 –1.86 –3.46 –1.83
110
–0.72
115
–0.04
120
0.32
ht

Then the second-order accurate ‘effective’ volatility λ is given as a solu- Expiry 2y 0.83 0.67 0.31 –0.25 –1.01 –0.23 0.14 0.20 0.07
tion to the equation: Expiry 3y 0.77 1.11 1.21 1.03 0.58 1.06 1.14 0.95 0.57
ig

 g ′′ (ζ) 2   g ′′ (ζ) 
Expiry 4y 1.23 1.85 2.18 2.18 1.88 2.21 2.16 1.83 1.33
ϕ0  − λ  = ϕ−  (20) Expiry 5y 1.91 2.68 3.13 3.24 3.03 3.27 3.14 2.75 2.18
 g ′ (ζ)   g ′ (ζ) 
yr

Expiry 6y 2.68 3.55 4.09 4.27 4.11 4.29 4.12 3.68 3.06
Expiry 7y 3.52 4.47 5.06 5.29 5.18 5.31 5.10 4.63 3.98
where:
op

ζ = z0 ∫0 σ 2 (t ) dt
T

and the function g(⋅) is given by (14). for S and 100 space points for z). We assume zero interest rates. The re-
C

We note that the expression on the right-hand side of (20) is easily (and
cheaply) computable (see the appendix). The expression on the left-hand
side (20) is available in closed form (see (23) in the appendix). Thus, the
equation (20) is trivial to solve for λ numerically. Because of the simplic-
ity of functions involved, obtaining the solution is extremely fast.
Test results
We test the three averaging results (on volatility of volatility γ(t), skew β(t)
and volatility σ(t)) separately, to demonstrate the performance of each one.
Initially, we are interested in the performance of the model for forex/eq-
uity markets, and thus focus on maturities typical for those markets. In the
first set of tests, we consider options with maturities one, two, ... , seven
years. The initial value of the spot S(0) is set to 100. The mean reversion
of volatility parameter θ is set to 30% throughout. Options with strikes 80,
85, ... , 120 (nine strikes in total for each option expiry) are valued. We
compare option values for a model with time-dependent parameters cal-
culated by our averaging methods (coupled with the standard Fourier in-
tegration method applied to the model with effective constant parameters
(see Andersen & Andreasen, 2002) against the benchmark values calcu-
lated by a direct application of the PDE method (two-dimensional alter-
nating-directions-implicit scheme with 400 time points, 400 space points
sults are reported in implied Black volatilities. Instantaneous parameters
are piece-wise constant on reported intervals.
■ Volatility-of-variance tests. In the first set of tests, we assess the ac-
curacy of the volatility-of-variance averaging method. The volatility para-
meter λ is set to 20% and the skew b to 100%. Time-dependent
volatility-of-variance parameter γ(t) is given in the second row of table A.
Volatility-of-variance parameters η (for expiries one, two, ... , seven years),
as calculated by (6) are reported in the third row.
Implied Black volatilities across all strikes/maturities are presented in
figure 1. The accuracy of the method is shown in table B. In it, we report
the differences in option values between the averaging method and the
benchmark PDE method. The values are reported in 1/10,000 of Black
volatilities, that is, ‘5.00’ means 0.05% difference.
As we can see from table B, the accuracy is excellent throughout, with
all differences within ±0.05%.
■ Skew tests. Next we test the skew averaging method. The volatility pa-
rameter λ is set to 20% and η to 100%. Time-dependent model skews β(t)
are given in the second row of table C. Effective skews b (for expiries one,
two, ... , seven years), as calculated by (11), are reported in the third row.
Implied Black volatilities across all strikes/maturities are presented in
figure 2. The accuracy of the method is demonstrated in table D, in the

WWW.RISK.NET ● MAY 2005 RISK 73

Cutting edge l Option pricing

C. Instantaneous and effective skew E. Instantaneous and effective volatility

Expiry (years) 0.02 1 2 3 4 5 6 7 Expiry(years) 0.02 1 2 3 4 5 6 7
Instantaneous skew 100% 85% 71% 56% 41% 26% 10% –5% Instantaneous vol 25.0% 22.9% 20.7% 18.4% 16.1% 13.8% 11.3% 8.4%
Effective skew 100% 90% 80% 70% 60% 50% 40% 30% Effective vol 25.0% 24.0% 23.0% 22.0% 21.0% 20.0% 19.0% 18.0%

2. Implied volatilities for the test of 3. Implied volatilities for the test of
skew averaging volatility averaging

21.0 26.0
25.0

Implied Black volatility (%)

Implied Black volatility (%)

20.5
24.0
20.0 23.0
22.0
19.5
21.0

ia
19.0 20.0
19.0

ed
18.5
7y 18.0 7y
18.0 5y 17.0 5y
iry

piry
3y
Exp

3y

M
17.5 16.0

Ex
80 85 90 1y 80 85 90 1y
95 100 105 95 100 105 110 115
110 115 120 120
Strike Strike
ve
D. Approximation error in the test of F. Approximation error in the test of
si
skew averaging volatility averaging
ci

Strike 80 85 90 95 100 105 110 115 120 Strike 80 85 90 95 100 105 110 115 120
In

Expiry 1y –0.89 –1.29 –1.47 –1.45 –1.25 –0.84 –0.45 –0.14 0.08 Expiry 1y –3.45 –1.78 –0.77 –0.46 –0.86 –0.46 –0.74 –1.55 –2.70
Expiry 2y –2.93 –2.90 –2.57 –2.00 –1.29 –0.50 0.21 0.78 1.20 Expiry 2y –5.73 –3.37 –1.74 –0.92 –0.92 –0.89 –1.58 –2.82 –4.44
Expiry 3y –5.25 –4.77 –3.95 –2.91 –1.77 –0.59 0.49 1.42 2.16 Expiry 3y –7.17 –4.52 –2.68 –1.70 –1.57 –1.64 –2.45 –3.82 –5.60
ht

Expiry 4y –7.28 –6.41 –5.22 –3.82 –2.34 –0.84 0.56 1.81 2.88 Expiry 4y –8.07 –5.39 –3.55 –2.55 –2.36 –2.47 –3.26 –4.62 –6.38
Expiry 5y –8.86 –7.69 –6.24 –4.59 –2.86 –1.12 0.54 2.06 3.42 Expiry 5y –8.58 –6.02 –4.26 –3.29 –3.09 –3.20 –3.94 –5.21 –6.87
ig

Expiry 6y –9.86 –8.52 –6.90 –5.10 –3.21 –1.30 0.56 2.30 3.91 Expiry 6y –8.72 –6.34 –4.72 –3.83 –3.62 –3.71 –4.38 –5.53 –7.05
Expiry 7y –10.23 –8.81 –7.12 –5.25 –3.28 –1.25 0.74 2.66 4.47 Expiry 7y –8.46 –6.34 –4.89 –4.10 –3.91 –3.98 –4.56 –5.56 –6.91
yr
op

same units as in the previous tests. this is a simulated set of market data, in practice they would be obtained
As we can see, the accuracy is again excellent, with all differences with- by fitting time-independent parameters of the model (3), (4) to market
in ±0.10% and most within ±0.05%. volatility smiles at various maturities, individually for each maturity.
C

■ Volatility tests. Finally, we test the volatility averaging method. The
skew b is set to 50% and η to 100%. Time-dependent model volatilities
σ(t) are given in the second row of table E. Effective volatilities λ (for ex-
piries one, two, ... , seven years) are reported in the third row.
Implied Black volatilities across all strikes/maturities are presented in
figure 3. The accuracy of the method is demonstrated in table F, with num-
bers in the same units as in the previous tests.
As we can see, the accuracy of this approximation is also very good,
with all differences within ±0.10% and most within ±0.05%.
■ Long-dated maturity tests. In previous tests, we considered maturities
typical for exotics in the forex/equity markets. Applications of our tech-
niques to the interest rate markets are potentially of significant interest as
well. In this section, we test the performance of the averaging methods for
longer-dated maturities typical of interest rate markets. In particular, we
consider options of five, 10, ... , 30 years to maturity. We also broaden the
range of strikes. For each option maturity, we consider strikes 60, 70, ...,
140. Instead of testing each parameter of the model separately, as we have
done in the previous test, we let them be time-dependent simultaneously.
In particular, we consider the market parameters (term volatility, skew and
volatility of variance to indicated option maturities) in table G.
These parameters represent volatility smiles at various maturities. While
With these parameters, implied Black volatilities across all strikes/ma-
turities are given in figure 4. We back out model parameters σ(t), β(t), γ(t)
from these term parameters by assuming the former are piece-wise con-
stant between maturities, and using the formulas developed previously (by
equating ‘effective’ parameters calculated from instantaneous ones using
our averaging method to the market parameters in the table, and solving
for instantaneous ones). Calibrated instantaneous parameters are given in
table H (piece-wise constant on time intervals).
As before, we compare ‘market’ option values (that is, values calculat-
ed via Fourier methods from constant ‘market’ parameters) versus PDE-
calculated option values in the model with time-dependent parameters.
Differences are given in table I, in the same units as before (in 1/10,000th
of Black volatilities). The agreement between the values is excellent for all
maturities and strikes, thus establishing the high level of performance of
the averaging methods for long-dated maturities.
Interestingly, the errors in the combined test appear to be smaller than
in the separate tests above. This is due to a combination of factors. First, er-
rors of different approximations tend to cancel each other. Second, a longer-
dated test is, in a way, ‘easier’ for the model to pass because the speed of
change, the degree of inhomogeneity, of various parameters is not as large.
In conclusion, we note that shorter-dated maturities show slightly high-

74 RISK MAY 2005 ● WWW.RISK.NET

 G. Effective volatility, skew and volatility of Appendix. Laplace transform of integrated
variance for the combined test stochastic variance
Expiry (years) 0.02 1 5 10 15 20 25 30 Recall the definitions:
Effective vol 20.0% 19.0% 18.0% 17.0% 16.0% 15.5% 15.0% 14.5%
Z (T ) = ∫0 σ 2 (t ) z (t ) dt
T
Effective skew 100% 90% 80% 70% 60% 55% 50% 45%
Eff vol of var 100% 110% 120% 130% 140% 145% 150% 155%
ϕ (µ )
E exp ( − µZ (T ))

4. Implied volatilities for the combined test

(
ϕ 0 (µ )
E exp − µ ∫ z (t ) dt
0
T
)
where the stochastic variance process z(·) follows (3). As explained
in Andersen & Andreasen (2002), the function ϕ(µ) can be repre-
20.0 sented as:
ϕ (µ ) = exp ( A (0, T ) − z0 B (0, T ))

Implied Black volatility (%)

19.0
18.0 where the functions A(t, T), B(t, T) satisfy the Riccati system of
17.0
ordinary differential equations (ODEs):
A′ (t , T ) − θz0 B (t , T ) = 0 (21)
16.0

ia
15.0 1
B ′ (t , T ) − θB (t , T ) − η2 B 2 (t , T ) + µσ 2 (t ) = 0 (22)

ed
14.0 2
13.0 with terminal conditions:
A (T , T ) = 0

M
12.0
5y
B (T , T ) = 0
80
10y 90 85
15y
Ex 20y 105 100 95
pir 25y 115 110 Strike ve The system of ODEs is trivial to solve numerically.
y 30y 120
The function ϕ0(µ) satisfies the same system of equations with
σ(t) ≡ 1. In this case, the equations can be solved explicitly, to
si
yield:
H. Instantaneous volatility, skew and volatility ϕ 0 (µ ) = exp ( A0 (0, T ) − z0 B0 (0, T ))
ci

of variance for the combined test

B0 (0, T ) =
(
2µ 1 − e − γT )
In

Expiry(years)
Inst vol
0.02 1 5 10 15 20 25 30
20.0% 18.6% 16.8% 14.8% 12.7% 13.4% 12.3% 11.2% ( )
(θ + γ ) 1 − e− γT + 2γe− γT
Inst skew 100% 88% 75% 55% 31% 38% 26% 12%  
ht

2θz0 2γ µ
A0 (0, T ) =
Inst vol of var 100% 121% 139% 174% 166% 165% 178% 186%
log   − 2θz0 T
η2
(
 θ + γ 1 − e − γT
) − γT
+ 2 γe   θ + γ (23)
ig

I. Approximation error in the combined test γ = θ 2 + 2 η2µ

yr
op

Strike 60 70 80 90 100 110 120 130 140

Expiry 5y –14.54–11.10 –6.53 –2.60 –0.79 –0.26 –1.62 –3.67 –5.64
Expiry 10y –13.79 –9.96 –5.90 –2.69 –0.88 0.11 –0.13 –1.07 –2.25
Expiry 15y –8.86 –5.57 –2.24 0.31 1.71 2.43 2.18 1.34 0.27 REFERENCES
C

Expiry 20y –7.41 –4.60 –1.94 0.06 1.22 1.92 1.92 1.44 0.74
Expiry 25y –3.94 –2.32 –0.69 0.53 1.23 1.67 1.63 1.27 0.77 Andersen L and J Andreasen, 2002
Expiry 30y –0.07 0.47 1.19 1.73 1.96 2.08 1.89 1.51 1.05 Volatile volatilities
Risk December, pages 163–168

Andersen L and R Brotherton-Ratcliffe, 2001

Extended Libor market models with stochastic volatility
er errors due to the higher discretisation error in the PDE grid for shorter- Working paper
dated, non-at-the-money options.
Hagan P, D Kumar, A Lesniewski and D Woodward, 2002
Conclusion Managing smile risk
Wilmott Magazine, November, pages 84–108
Calibration of stochastic volatility models with time-dependent parameters
can be accomplished very accurately and efficiently with the parameter av- Piterbarg V, 2004
eraging formulas derived in this article. Test results indicate that approxi- A stochastic volatility model with time-dependent skew
Forthcoming in Applied Mathematical Finance
mations are excellent throughout. The method can be applied in many
markets, as long as the dynamics (1), (2) are deemed reasonable for the Zhou F, 2003
market quantities of interest.3 ■ Black smirks
Risk May, pages 87–91
Vladimir Piterbarg is the head of fixed-income quantitative research at
Barclays Capital in London. He would like to thank Leif Andersen, Paul 3 As pointed out by one of the referees, forex and other derivatives become interest rate
Cloke, Phil Hinder and Jesper Andreasen for their interest in this work, sensitive as they become more long-dated, and thus the dynamics (1) and (2) may cease
help and support, and referees for comments that greatly improved the to be sensible. We note that in some markets, this difficulty can be overcome by a suitable
article. Email: Vladimir.Piterbarg@BarclaysCapital.com measure choice, while in others, appropriate extensions of the method are required

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