Some Things I Have Learned About Volatility Over The Years Notes

Some Things I Have
Learned About Volatility

Over The Years
In this lecture. . .
• Why does volatility matter?
• How can you make money from volatility?
• What would happen if you hedge with the wrong

volatility?
• What would a good volatility model look like?

c Paul Wilmott www.wilmott.com
1
In the companion lecture (CQF Institute Christ-
mas Lecture, Dec. 14th, London). . .
• What is sensitivity to volatility?
• Where do prices come from?
• What information is contained in market prices?
• How important is it to get volatility right?
• Do you need to dynamically hedge?

2
Introduction
There are thousands of papers on volatility. Some are

about volatility modelling, some on the implementation
of the models. The popularity of the models is driven
by two main features:
• The model must not admit arbitrage (or rather, it

must not give the appearance of arbitrage opportu-
nities)
• Ideally there will be an element of tractability, per-

haps in terms of closed-form solutions
I don’t approve of either of these! And this disapproval

guides much of my research...

3
Why does volatility matter?
It matters because of two things:
1. Randomness
2. Nonlinearity
Jensen’s Inequality!

4
Jensen’s Inequality

5
If f (x) is a convex function and x is a random variable
then
E[f (x)] ≥ f (E[x]).
If the variance of x is small then you can get an ap-

proximation for the difference between the two sides
as:
2

1 ∂ f
var(x) 2 .
2 ∂x x=E[x]

6
How can you make money from volatility?
Suppose that you believe an option is mispriced. . . how

can you profit from this?
Remember that if you are delta hedging then you are

only exposed to volatility and not market direction.
So you can interpret a ‘mispriced’ option as one for

which your estimate of volatility differs from the implied
volatility.

7
You have a forecast of volatility, and so does the market
(implied).
Black–Scholes tells you all about how to hedge when

there is just one volatility, now there are two!
So which delta do you choose? Delta based on actual

or implied volatility?

8
Hedging with actual volatility or implied volatility?
Scenario: Implied volatility for an option is 20%, but

we believe that actual volatility is 30%
Question: How can we make money if our forecast is

correct?

9
Answer: Buy the option and delta hedge.
But what delta do we use?
∆ = N (d1)
where
1 x s2
Z
−
N (x) = √ e 2 ds
2π −∞
and

1 2
ln(S/E) + r + 2 σ (T − t)
d1 = √ .
σ T −t

10
We can all agree on S, E, T − t and r (almost), but not
on σ.
So should we use σ = 0.2 or 0.3?

11
σa = actual volatility, 30%
and
σi = implied volatility, 20%.

12
Case 1: Hedge with actual volatility, σa
By hedging with actual volatility we are replicating a

short position in a correctly priced option.
The payoffs for our long option and our short replicated
option will exactly cancel.
The profit we make will be exactly the difference in the

Black–Scholes prices of an option with 30% volatility
and one with 20% volatility.
(Assuming that the Black–Scholes assumptions hold.)

13
If V (S, t; σ) is the Black–Scholes formula then the guar-
anteed profit is
V (S, t; σa) − V (S, t; σi).
But how is this guaranteed profit realized?

14
The model
dS = µS dt + σaS dX.
Set up a portfolio by buying the option for V i and hedge

with ∆a of the stock.
Today:
Option Vi
Stock −∆a S
Cash −V i + ∆a S
Superscript ‘a’ means actual and ‘i’ means implied,

these can be applied to deltas and option values.

15
Tomorrow:
Option V i + dV i
Stock −∆a S − ∆a dS
Cash (−V i + ∆a S)(1 + r dt)

16
Therefore we have made, mark to market,
dV i − ∆a dS − r(V i − ∆a S) dt.
After a bit of Itô this becomes

1 σ 2 − σ 2 S 2 Γi dt + (∆i − ∆a ) (µ − r)S dt + σ S dX .
2 a i ( a )
Conclusion: The final profit is guaranteed (the dif-

ference between the theoretical option values with the
two volatilities) but how that is achieved is random.
On a mark-to-market basis you could lose before you

gain.

17
P&L for a delta-hedged option on a mark-to-market
basis, hedged using actual volatility.

18
When S changes, so will V . But these changes do not
cancel each other out.
The fluctuation in the portfolio mark-to-market is ran-

dom. It may even go negative.
Although the path of the profit is random, the final

profit is simply the difference between the option valued
using actual volatility and that using implied volatility.
This is a known quantity.

19
An analogy, a bond: Guaranteed outcome, but may
lose on a mark-to-market basis in the meantime. May
be difficult to exit.

20
Case 2: Hedge with implied volatility, σi
By hedging with implied volatility we are balancing the

random fluctuations in the mark-to-market option value
with the fluctuations in the stock price.
The evolution of the portfolio value is ‘deterministic.’

21
Let’s see how this works.
Buy the option today, hedge using the implied delta,

and put any cash in the bank earning r.
The mark-to-market profit from today to tomorrow is
dV i − ∆i dS − r(V i − ∆iS) dt
Θi dt + 1 σ
2 a
2 S 2 Γi dt − r(V i − ∆i S) dt

1 2 2
= 2 σa − σi S 2Γi dt.

22
Add up the present value of all of these profits to get
a total profit of
Z T
e−r(t−t0)S 2Γi dt.

1 σ2 − σ2
2 a i
t0
This is always positive, but path dependent.

23
P&L for a delta-hedged option on a mark-to-market
basis, hedged using implied volatility.

24
An analogy, money in the bank: Can access money
at any time, easy to exit. Always increasing in value.
End result uncertain.

25
What would happen if you hedge with the wrong volatility?
We will briefly examine hedging using volatilities other

than actual or implied.

26
Actual volatility = Implied volatility
For the first example let’s look at hedging a long po-

sition in a correctly priced option, so that σ = σ̃. We
will hedge using different volatilities, σ h. The figure
shows the expected profit and standard deviation of
profit when hedging with various volatilities. The chart
also shows minimum and maximum profit. Parameters
are E = 100, S = 100, µ = 0, σ = 0.2, r = 0.1, D = 0,
T = 1, and σ̃ = 0.2.

27

28
Actual volatility > Implied volatility
Next we see the expected profit and standard deviation

of profit when hedging with various volatilities when
actual volatility is greater than implied. The chart again
also shows minimum and maximum profit. Parameters
are E = 100, S = 100, µ = 0, σ = 0.4, r = 0.1,
D = 0, T = 1, and σ̃ = 0.2. Note that it is possible to
lose money if you hedge at below implied, but hedging
with a higher volatility you will not be able to lose until
hedging with a volatility of approximately 75%. The
expected profit is again insensitive to hedging volatility.

29

30
Actual volatility < Implied volatility
Next is shown properties of the profit when hedging

with various volatilities when actual volatility is less than
implied. We are now selling the option and delta hedg-
ing it. Parameters are E = 100, S = 100, µ = 0,
σ = 0.4, r = 0.1, D = 0, T = 1, and σ̃ = 0.2. Now it is
possible to lose money if you hedge at above implied,
but hedging with a lower volatility you will not be able
to lose until hedging with a volatility of approximately
10%. The expected profit is again insensitive to hedg-
ing volatility. The downside is now more dramatic than
the upside.

31

32
To a large extent how you hedge matters less than
doing some hedging.
Already this is hinting that using the right model, say

a calibrated model, does not matter as much as you’d
expect.
I shall return to this subject in Part 2 of this talk.

33
What would a good volatility model look like?
What people want from a volatility model:
• The academic wants a complex piece of mathemat-

ics
• The trader wants whatever will hide the most risk
• The risk manager wants to use whatever models
other people are using
• The boss wants to be able to trust his employees’
models
• The regulator wants to seem cleverer than he really
is
Above everything, they all want “Plausible Deniability.”

34
What doesn’t matter
• The distribution of returns doesn’t matter. If you

are hedging often enough then all that matters is
finite variance of returns
• Fat tails are misleading. Extreme events should not

treated in a probabilistic way
What really matters
• If selling OTC derivatives: Hedging, both static and

dynamic; Adding a decent profit margin
• If speculating: A good model for what you are spec-

ulating on. (And no arbitrage is obviously wrong!)

35
What people should want from a volatility model
Being a responsible person you might say you want. . .
• A good approximation to reality
• Usable and transparent. It’s no good having a model

that is only understood by the professors!
• Makes its faults known. Accept that there will be

risks you don’t know, and model error

36
What models can do
Mathematical models can do a lot more than you think.
The vast majority of derivatives models use the same

mathematics. The end result is in 99% of cases:
“The value of an option is the present value of the

expected payoff under the risk-neutral random walk.”
And this then allows valuation by Monte Carlo simula-

tion.
So what is the point of quant finance research, if every

paper is the same?

37
Some good models
• Constant volatility. Why is no one taught the basics

of volatility arbitrage?
• Uncertain Volatility Model: σ − < σ < σ +. Nonlin-

earity
• Stochastic volatility without dynamic hedging of

one option with another. Nonlinearity
• Anchoring model: dS = µS dt+σ(S/A)S dX where A

R t −λ(t−τ )
is weighted average of past prices, A = λ ∞ e S(τ ) dτ

38
The Anchoring model
We need an antidote to the deterministic volatility model

— Yeugh!
dS = µ S dt + σ(S) S dX
And the antidote is...the Anchoring model!...

39
We are going to work with a model that has a memory.
Let us introduce a new variable A, representing averag-
ing or, in the language of behavioral finance, anchoring
Z t
A=λ e−λ(t−τ )S(τ ) dτ.
∞
Note that this is just about the simplest memory func-

tion that has tractable properties.
We have a volatility function σ(ξ), to be determined,

where
S
ξ= .
A

40
If you multiply S everywhere by a constant then the
variable ξ is unchanged. Thus the model has a nice
scaling property.
Our model is thus
dS = µS dt + σ(ξ)S dX.
Such a volatility function can be made consistent with

the common observation that volatility increases when
prices are low, but crucially this means low relative to
some historical average, not simply low in an absolute
sense since that would be contrary to our scaling re-
quirement.

41
Qualitative Observation On Share Prices Generally

42
In the figure are two lines, one the logarithm of the
Standard and Poor’s Index from 1950 until March 2012,
detrended, and the second is the inverse of the index.
If we were dealing with simple, classical lognormal ran-

dom walks then the choppy (i.e. Brownian Motion)
nature of these two lines would be qualitatively simi-
lar. But there is one aspect of the real financial time
series that is different from its mirror image: The ar-
tificial data, the mirror image, has peaks and troughs
like a classical sea wave, the peaks being pointy and the
troughs being rounded. With the real data this picture
is upside down. The real data has pointed troughs and
rounded crests. This is suggestive of higher volatility
for lower share prices.

43
Observations On ξ
By examining the stochastic differential equation for ξ

in isolation we can tell a great deal about the behavior
of this model, and get some clues as to how to approach
the determination of a functional form for σ and for
determining a value for λ.
dξ = (µ + λ − λξ) ξ dt + σ(ξ)ξ dX.

44
After a bit of Fokker–Planck and some data analysis we
find that a good fit for σ(ξ) is the sigmoidal function
b−a
a+ .
1 + e−c(ln(ξ)−d)
The best-fit parameters are
a = 0.60, b = 0.12, c = 10.82, d = −0.27 and λ = 0.90.

The last of these shows a typical memory of the order
of one year.

45

46

47
Summary
Please take away the following important ideas
• There are probably more math models than you

know about
• People choose models for very narrow, personal,

reasons
• If a model is popular it’s almost certainly bad

48

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Some Things I Have

Learned About Volatility

• Why does volatility matter?

• How can you make money from volatility?

• What would happen if you hedge with the wrong

• What would a good volatility model look like?

• What is sensitivity to volatility?

• Where do prices come from?

• What information is contained in market prices?

• How important is it to get volatility right?

• Do you need to dynamically hedge?

There are thousands of papers on volatility. Some are

• The model must not admit arbitrage (or rather, it

• Ideally there will be an element of tractability, per-

I don’t approve of either of these! And this disapproval

It matters because of two things:

If the variance of x is small then you can get an ap-

Suppose that you believe an option is mispriced. . . how

Remember that if you are delta hedging then you are

So you can interpret a ‘mispriced’ option as one for

Black–Scholes tells you all about how to hedge when

So which delta do you choose? Delta based on actual

Scenario: Implied volatility for an option is 20%, but

Question: How can we make money if our forecast is

But what delta do we use?

So should we use σ = 0.2 or 0.3?

By hedging with actual volatility we are replicating a

The profit we make will be exactly the difference in the

(Assuming that the Black–Scholes assumptions hold.)

V (S, t; σa) − V (S, t; σi).

But how is this guaranteed profit realized?

Set up a portfolio by buying the option for V i and hedge

Superscript ‘a’ means actual and ‘i’ means implied,

Conclusion: The final profit is guaranteed (the dif-

On a mark-to-market basis you could lose before you

The fluctuation in the portfolio mark-to-market is ran-

Although the path of the profit is random, the final

This is a known quantity.

By hedging with implied volatility we are balancing the

The evolution of the portfolio value is ‘deterministic.’

Buy the option today, hedge using the implied delta,

The mark-to-market profit from today to tomorrow is

This is always positive, but path dependent.

We will briefly examine hedging using volatilities other

For the first example let’s look at hedging a long po-

Next we see the expected profit and standard deviation

Next is shown properties of the profit when hedging

Already this is hinting that using the right model, say

I shall return to this subject in Part 2 of this talk.

What people want from a volatility model:

• The academic wants a complex piece of mathemat-

• The distribution of returns doesn’t matter. If you

• Fat tails are misleading. Extreme events should not

What really matters

• If selling OTC derivatives: Hedging, both static and

• If speculating: A good model for what you are spec-

Being a responsible person you might say you want. . .

• A good approximation to reality

• Usable and transparent. It’s no good having a model

• Makes its faults known. Accept that there will be

Mathematical models can do a lot more than you think.

The vast majority of derivatives models use the same

“The value of an option is the present value of the