Autonomy Presentation

Carr-Lee Method for Volatility Swap Valuation
OpenGamma Quantitative Research Group

OpenGamma, Inc.
Feb. 21, 2014
OpenGamma Quantitative Research Group (2014) Carr-Lee Method for Volatility Swap Valuation Feb. 21, 2014 1 / 32
Outline
1
Introduction
2
Outline of the Replication Arguments
3
Correction to Carr-Lee Formula
4
Numerical Integration for Seasoned Vol Swaps
5
Diagnostic Outputs
6
Appendix
Outline
1
Introduction
2
3
4
5
Diagnostic Outputs
6
Appendix
Outline
1
Introduction
2
3
4
5
Diagnostic Outputs
6
Appendix
Outline
1
Introduction
2
3
4
5
Diagnostic Outputs
6
Appendix
Outline
1
Introduction
2
3
4
5
Diagnostic Outputs
6
Appendix
Outline
1
Introduction
2
3
4
5
Diagnostic Outputs
6
Appendix
Introduction
payoff and exposures
Some notations
Vol swaps are forward contracts on future realized volatility. At
expiry it pays the difference between the realized vol and the
strike.
100 N (R
[,T]
K)
Vol swaps provide almost pure exposure to volatility. They can be
used to express views on future realized vol or speculate on the
spread between realized and implied vol.
Introduction
payoff and exposures
Some notations
: the effective date of the swap
T: the maturity date of the swap
t : the valuation date
u: Normalization factor as the fraction of a 252-day year.
t
n
: n-th observation dates between the swap inception time
and expiry T.
R
2
[,T]
:= u
N
n=1
_
log
_
S
t
n
S
t
n1
__
2
: daily monitored total realized
variance of log-return.
K: the strike of the swap
Introduction
Valuation methodologies: variance swap
Inequality involving implied vol, fair vol swap strike and fair
variance swap strike (a useful sanity check)
Valuation methodologies: volatility swap
A closed related instrument: variance swap.
Pays realized quadratic variation minus strike

10, 000 N
_
R
2
,T
K
_
The expected fair variance can be expressed as the PV of a log

prole. To the extend that the price process is continuous, this
result is model free.
European payoff proles may be replicated with European vanilla

OTM calls and puts.
This replication strategy is static in option positions.

Introduction
Dene
IV
0
: ATM Implied vol
VOL
0
:= E
0
_
X
T
: The vol swap model vol at inception
VAR
0
:=
_
E
0
X
T
: The variance swap model vol at inception
Then we have the inequality
2
S
0
E
0
{S
T
S
0
}
+
IV
0
VAR
0
=
_
2E
0
log
_
S
T
S
0
_
.
Here, all but IV
0
< VOL
0
are model free, which assumes the independence of vol and spot process.
Fair Volatility vs. ATM implied vol
Introduction
Volatility swaps underlying is a nonlinear function of QV
Jensens inequality implies fair variance to be greater than the

square of implied fair volatility. The difference is the convexity
adjustment and is related to vol of vol.
Direct approaches
Model the vol process. For example, by a Heston process: Not model
free.
Estimate the convexity adjustments: Does not directly give replicating

portfolio.
Introduction
Carr-Lee replication arguments:
model free replication
exact for independent spot and vol process
rst order immune to spot and vol correlation

Independent Spot and Vol Processes Case
Assume zero interest rate, and underlying price S
t
follows a
diffusion process:
S
t
SDE:
dS
t
= S
t
t
dW
t
By Itos Lemma: The SDE for x
t
:= log
_
S
t
S
0
_
is
dx
t
=
1
2
2
t
dt +
t
dW
t
where
2
t
= dx
t
.
Assuming
t
process is independent of x
t
: Then conditional on a vol
path
.
, x
T
at a xed T is normally distributed with mean
1
2
x
T
and variance x
T
.
Consider the pricing of a power payoff
_
S
T
S
0
_
p
= e
px
T
:
Using the identity
_

e
px
1
2
e
2
2
+x
_
2
2
2
dx = e
1
2
(
p
2
p
)
2
we have
E
_
e
px
T
_
= E
_
e
(p
2
/2p/2)x
T
_
=: E
_
e
(p)x
T
_
Invert the order of the equality; express p in terms of , we have
the basic pricing of exponentials:
Interpretation: under independence assumption, the information in
T-expiry option prices fully reveals the distribution not only of S
T
,
but also of X
T
!
For each C and t T,
E
t
e
X
T
= e
X
t
E
t
_
S
T
S
t
_1
2
1
4
+2
(1)
Invert the order of the equality; express p in terms of , we have
the basic pricing of exponentials:
Interpretation: under independence assumption, the information in
T-expiry option prices fully reveals the distribution not only of S
T
,
but also of X
T
!
The PV of power payoff in fact gives the characteristic function of
the distribution of the underlying
Here we see the power payoff of price is related to the power
payoff of QV (with a different power)
As any European payoff can be replicated with vanilla calls and
puts, T-expiry options can replicate European payoff on QV
including volatility swap.
The general formulation of the replication problem
Under independence assumption, we have an innite family of
European payoff proles that can precisely replicate variance
payoff!
For dependent case: different payoffs are no longer the same
Given a desired function h of variance, we nd a formula for a function
G of price, such that,
E{h (X
T
)} = E{G(S
T
)} (2)
payoff!
F
t
measurable random variable , we have
E
t
e
X
T
= e
X
t
E
t
_
_
_
(1 )
_
S
T
S
t
_1
2
+
1
4
+2
+
_
S
T
S
t
_1
2
1
4
+2
_
_
_
payoff!
If we relax the independence assumption:
We will no long be able to precisely price any function of the
variance
but we will be able to nd a member of this family, so that the
pricing result is least sensitive to the correlation assumption
Back to the independent case, with the distribution of the variance
available, we may compute any payoff on variance. But we want a
simple closed form G(S
T
) for volatility swap. . .
a neat identity for the close form solution of vol swap model vol:
q
r
=
r
(1 r )
_

0
1 e
zq
z
r +1
dz, 0 < r < 1, q 0
in particular,
q =
1
2
_

0
1 e
zq
z
3/2
dz, q 0
Back to the independent case, with the distribution of the variance
available, we may compute any payoff on variance. But we want a
simple closed form G(S
T
) for volatility swap. . .
E
0
_
X
T
=
1
2
_

0
E
0
1 e
zX
T
z
3/2
dz
=
1
2
_

0
E
0
1 e
_
1
2
1
4
2z
_
X
T
z
3/2
dz =
1
2
E
0
_

0
1 e
_
1
2
1
4
2z
_
X
T
z
3/2
dz.
The next step: replicating the European payoff with vanilla options
The replication formula for vol swap under independence
assumption
Using the identity x R
+
, R
+
,
G(x) = G()+G
()(x)+
_
K
G
(K)(xK)
+
dK+
_
0<K<
G
(K)(Kx)
+
dK.
We may take second derivative wrt the payoff
G(S
T
) :=
_

0
1
_
S
T
S
0
_
_
1
2
1
4
2z
_
z
3/2
dz
and make the substitution S
T
K, integrate out wrt z, we obtain the
replication formula
The next step: replicating the European payoff with vanilla options
The replication formula for vol swap under independence
assumption
(Friz and Gatheral (2005)) Let C(F
0
, K, T) be the BS call option price
with expiry T, strike K and forward F
0
, then
E
_
_
X
T
_
=
2
F
0
C(F
0
, F
0
, T)
+
_
2
_

F
0
1
K
1/2
F
3/2
0
I
1
_
log
_
K
F
0
__
C(F
0
, K, T)dK
Dependent Spot Vol Case: Mixing Formula
For a case where there is nonzero spotvol correlation:
The BS formula of a European payoff: PV conditional on the vol
path
dS
t
=
_
1
2
t
S
t
dW
1t
+
t
S
t
dW
2t
where is independent of W
1
, and W
2
is independent of W
1
.
path
Notations: for t T,
B: Borrel set of R
+
F : R
+
R: F: (B
F
t
)measurable time-t constructed
European payoff function.
Example: The ATM call constructed at time t can use S
t
as the
strike:
F(S) = (S S
t
())
+
= (S S
t
)
+
path
Dene F
BS
: R
+
R : for F as
F
BS
(S, , ) :=
_

0
F(Sy, )
1
2y
e
_
y+
2
2
_
2
2
2
dy
It follows that F
BS
(S, 0, ) = F(S, ).
path
Dene
Effective drift: M
t ,T
() := exp
_
2
2
_
T
t

2
u
du +
_
T
t

u
dW
2u
_
.
Effective volatility:
t ,T
:=
_
_
T
t

2
u
du
_
1/2
.
(Romano and Touzi (1997)) Then the price of european payoff under
correlated spot-vol:
E
t
F (S
T
) = E
t
F
BS
_
S
t
M
t ,T
(),
t ,T
_
1
2
_
Dependent Spot Vol Case: Correlation Immunization
First order expansion around independent case:
O
_
2
_
-immune to correlation.
Expanding arround = 0, we have
E
t
F (S
T
) E
t
F
BS
_
S
t
,
t ,T
_
+ S
t
E
t
_
F
BS
S
_
S
t
,
t ,T
_
_
T
t
u
dW
2u
_
+O
_
2
_
First order expansion around independent case:
O
_
2
_
-immune to correlation.
If
F
BS
S
is independent of the random vol, then this is O
_
2
_
immune to
correlation.
Formally, F is -neutral if BS delta is independent of vol:
F
BS
S
(S
t
, ) = c, 0
payoff!
Q: What is s.t. the European payoff of volatility swaps BS delta
is independent of vol?
F
t
measurable random variable , we have
E
t
e
X
T
= e
X
t
E
t
_
_
_
(1 )
_
S
T
S
t
_1
2
+
1
4
+2
+
_
S
T
S
t
_1
2
1
4
+2
_
_
_
payoff!
Q: What is s.t. the European payoff of volatility swaps BS delta
is independent of vol?
A:
:=
1
2

1
2
1 8z
In fact in this case,
F
BS
S
(S
t
) = 0.
Appendix: Demo of Correlation Neutrality
Dependent Spot Vol Case: Main Result (no
annualization)
The replicating European payoff for volatility swap:
The replicating portfolio for volatility swap (option positions):
(z) and p
(z):
The replicating portfolio for volatility swap (cash position):
The expected volatility is given by
E
t
_
X
T
= E
t
_
_
1
2
_

0
_
+
1 e
zX
t
_
S
T
S
t
_
p
+
z
3/2
+
1 e
zX
t
_
S
T
S
t
_
p
z
3/2
_
_
dz
_
_
annualization)
(z) and p
(z):
The replicating portfolio consists of
dK
_

0
1
K
2
z
e
zX
,t
_
_
K
F
_
p
+
+
_
K
F
_
p
+
_
dz.
call at strikes K > F
and put with strikes F
> K, where the realized

quadratic variation
X
t ,
:=
<t
n
<t
log
2
_
S
t
n
S
t
n1
_
.
annualization)
(z) and p
(z):
with
p
+
(z) :=
1
2
+
1
2
_
1 8z
p
(z) :=
1
2

1
2
_
1 8z
+
:=
1
2

1
2
1 8z
:=
1
2
+
1
2
1 8z
annualization)
(z) and p
(z):
The cash position is the european prole evaluated at S
T
= S
0
:
e
r (Tt )
_
X
,t
annualization)
Special case: when X
,t
= 0, the integral evaluates into a closed
form expression involving Bessel functions
The payoff function is discontinuous at S
T
= F
0
, giving rise to a
function weight on the ATM Straddle for newly issued vol swaps
With the help of Struve function, we have the replicating portfolio
weights
K
_

8K
3
F
_
_
_
_
I
1
(
k
2
) I
0
(
k
2
)
_
fork > 0
_
I
0
(
k
2
) + I
1
(
k
2
)
_
fork < 0
annualization)
Special case: when X
,t
= 0, the integral evaluates into a closed
form expression involving Bessel functions
The payoff function is discontinuous at S
T
= F
0
, giving rise to a
function weight on the ATM Straddle for newly issued vol swaps
_
2
1
F
0
ATMF straddels
Annualization for Realized Vol and Fair Model Vol
The annualization in Realized Volatility and Variance: Options via
Swaps by P. Carr and R. Lee
The replicating portfolio
For practical implementation with daily monitoring, however, let N be the
number of days in the period [0, T] between the daily closing times 0 and T,
and let
R
2
,t
:= u
2

<t
n
<=t
_
log
S
t
n
S
t
n1
_
2
where t
0
:= and the t
1
< t
2
< . . . are the successive daily closing times in
(, t ], together with t itself; and u is a constant annualization/rescaling factor.
For example, choosing u := 100
_
252/N expresses R
2
0,T
in units of annual
bp.
Annualization for Realized Vol and Fair Model Vol
The annualization in Realized Volatility and Variance: Options via
Swaps by P. Carr and R. Lee
The replicating portfolio
Afterwards, at times t > when R
2
,t
> 0, it holds
u
dK
_

0
e
z
R
2
,t
u
2
1
K
2
z
1/2
{
+
(K/F
t
)
p
+
+
(K/F
t
)
p
}
for calls at strikes K > F
t
and puts at strikes K < F
t
and
e
r (Tt )
R
,t
cash
Annualization for Realized Vol and Fair Model Vol in
OG implementation
To be consistent with the non-annualized results, we compute two
annualization factor u and u
seasoned
:
Notations:
N
seasoned
: the number of business days the vol swap contract has
seasoned after the inception date.
N: the number of business days until the delivery date of the
vol swap contract.
Dene
T
seasoned
:=
N
seasoned
252
T :=
N
252
OG implementation
To be consistent with the non-annualized results, we compute two
annualization factor u and u
seasoned
:
The scaling factor for the total volatility (including both realized and
expected) over the entire life of the vol swap:
u :=
100
_
T
seasoned
+ T
The scaling factor for the realized volatility
u
seasoned
=
100
_
T
seaoned
OG implementation
Annualization of the realized vol:
The replicating option position weights:
The cash position:
R
2
,t
:= u
2
seasoned
<t
n
t
_
log
S
t
n
S
t
n1
_
2
In this denition, R
,t
is given as annual bps unit.
OG implementation
The cash position:
the replicating portfolio weights is now given by
u
dK
_

0
e
z
R
2
,t
u
2
seasoned
1
K
2
z
1/2
_
+
(K/F
t
)
p
+
+
(K/F
t
)
p
_
for calls at strikes K > F
t
and puts at strikes K < F
t
.
OG implementation
The cash position:
e
r (Tt )
u
u
seasoned
R
,t
cash.
This new form allows R
,t
to be interpreted as annual bps unit.
The replicating portfolio is consistent with the non-annualized
results.
Numerical Integrations
We wish to evaluate numerically integral of the form:
p
(z),
(z) switch from purely real to purely imaginary at

z = 1/8, so expressing into integral along real lines, we have
dKu
_

0
1
K
2
z
e
zR
2
,t
u
2
seasoned
_
_
K
F
_
p
+
+
_
K
F
_
p
+
_
dz
We wish to evaluate numerically integral of the form:
p
(z),
(z) switch from purely real to purely imaginary at

z = 1/8, so expressing into integral along real lines, we have
setting r :=
R
2
,t
u
2
seasoned
and k:=log
_
K
F
_
,
the integral simplies to an integration along the real line:
Ke
k/2
u
K
2
_
2
2
_
/2
0
e
r
8
sin
2
(t )
_
cos(t ) cosh(
k
2
cos(t )) sinh(
k
2
cos(t ))
_
dt +
2
2
_

0
e
r
8
(1+t
2
)
1 + t
2
_
t cos(
k
2
t ) sin(
k
2
t )
_
dt
_
The rst integral is over nite range, and the integrand is well behaved, but
the second integral is tricky.
The second integral as a function of k = log
_
K
F
_
for r = 0.01.
_
K
F
_
for r = 0.001.
Question
Figure: The second integral, r = 0.01
1.0 0.5 0.5 1.0
5
10
15
Exp
r
8
2
2

0
Exp
r
8
y
2
1 y
2
y Cos
k
2
ySin
k
2
y y vs. close form r 0
_
K
F
_
for r = 0.01.
_
K
F
_
for r = 0.001.
Question
Figure: The second integral, r = 0.001
1.0 0.5 0.5 1.0
10
20
30
40
50
Exp
r
8
2
2

0
Exp
r
8
y
2
1 y
2
y Cos
k
2
ySin
k
2
y y vs. close form r 0
_
K
F
_
for r = 0.01.
_
K
F
_
for r = 0.001.
Question
How to select the range of strikes in the replicating portfolio? (Fincad
seems to require users to input the range.)
Heuristics for the range of the strikes
To estimate the width of the bell curve, we follow the following
strategy:
To estimate the area under the weight curve, we consider the rst
order derivative of the payoff function:
1
Estimate the area under the strikeweight curve
2
Estimate the height of the strikeweight curve
3
Use Normal distribution as a proxy to estimate the width
To estimate the width of the bell curve, we follow the following
strategy:
To estimate the area under the weight curve, we consider the rst
order derivative of the payoff function:
The weight curve is the second order derivative of the generalized
payoff, therefore, its integral is the rst order derivative of the payoff
function. This is where we approach the estimation of the weight curve
around k = 0. The rst order derivative of the payoff is given by
e
k
2
(
2u)
K
_
e
r
8
_

0
e
r
8
t
2
1 + t
2
sin(
k
2
t )dt
+
_
2
0
e
r
8
sin(t )
2
sinh(
k
2
cos(t ))dt
_
at r = 0, it reduces to the closed form expression:
Plotting the rst derivative as r 0 as well as the analytical
expression at r = 0:
u
sgn(k)
F
2
e
k
2
I
0
(
k
2
)
The area is given by the jump in rst derivative, which is roughtly 2.
Figure: The rst order derivative of the generalized payoff, r = 0.01
2 1 1 2
1.0
0.5
0.5
1.0
r 0.01
Figure: The rst order derivative of the generalized payoff, r = 0.001
2 1 1 2
1.0
0.5
0.5
1.0
r 0.001
The height of the curve at r = 0 evaluates to:
The width of strikes: roughly 3
r
The range of the strike implemented for the replication algorithm:
Consider the integral for k = 0,
2
2
_

0
e
r
8
(
1+t
2
)
t
1 + t
2
dt =
erfc
_

r
2
2
_
r
.
r
Using Gaussian distribution as a proxy, the height is
1
2
and the
width, , then the area under the curve is 1. So, 3
r seems to be a
good proxy for the range of the log strikes.
r
Lower Range: min
_
strike(10 delta put), F
e
3.0
realizedQV
u
season
_
Higher Range: max
_
strike(10 delta call), F
e
3.0
realizedQV
u
season
_
Empirical Tests for Range of Strikes
Plotting the kwidth against r vs. 3
r , we have:
Figure: Empirical vs. Theoretical Width
0.0 0.1 0.2 0.3 0.4 0.5
r 0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
width
Dist. btwn Extema of 1st Derivatv
0.0 0.1 0.2 0.3 0.4 0.5
r 0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
width
3 r
r:
R
,t
2
useasoned
vs the width of the second integral in k:log
K
F
Diagnostic Outputs
Diagnostic outputs
The setup for an actual pricing example
Spot: 1.35285 for EURUSD
Time to Maturity: 0.076712329
Domestic interest rate at maturity: 0.06%
Foreign interest rate at maturity: 0.082%
Vol curve at maturity: at the deltas {10.0, 25.0, 50.0, 25.0,
10.0 }, the vol curve is {7.572, 7.069, 6.622,
6.472, 6.526 }.
Diagnostic Outputs
Diagnostic outputs
Vanilla portfolio weight for seasoned swaps
Vanilla portfolio weight for Newly issued vol swap
Figure: Vanilla portfolio weight for seasoned swaps
0.02 0.01 0.01 0.02
0.5
1.0
1.5
2.0
Vanilla Port. weight for seasoned vol swap
Diagnostic Outputs
Diagnostic outputs
Vanilla portfolio weight for seasoned swaps
Vanilla portfolio weight for Newly issued vol swap
Figure: Vanilla portfolio weight for Newly issued vol swap
0.02 0.01 0.01 0.02
0.005
0.005
Vanilla Port. weight for corresponding newly issued volswap
Diagnostic Outputs
Diagnostic outputs
First order derivative of the payoff function of newly issued vol
swaps
Figure: First order derivative of the payoff function of newly issued vol swaps
0.02 0.01 0.01 0.02
300
200
100
100
200
300
First order derivative of the payoff function for newly issued vol swap
Diagnostic Outputs
Diagnostic outputs
First order derivative of the payoff function of seasoned vol swap
Figure: First order derivative of the payoff function of seasoned vol swap
0.02 0.01 0.01 0.02
300
200
100
100
200
300
First oder derivative of the payoff function for seasoned vol swap
Diagnostic Outputs
Diagnostic outputs
Theoretical generalized payoff vs. implied payoff with discrete
strikes
Figure: Theoretical generalized payoff vs. implied payoff with discrete strikes
0.02 0.01 0.01 0.02
2
4
6
8
theoretical vs. numerical replicatingweights: The difference is cash, realizedQV
Diagnostic Outputs
Diagnostic outputs
The generalized payoff for newly issued vs. seasoned vol swaps.
Note the absence of kink at k = 0.
Figure: The generalized payoff for newly issued vs. seasoned vol swaps.
Note the absence of kink at k = 0.
0.02 0.01 0.01 0.02
2
4
6
8
10
12
The generalizedpayoff function for newly issued and seasoned vol swaps
Diagnostic Outputs
Implementation Tests
Flat vol surface test
Other tests
Direct integration with Gaussian density shows that, if
The vol surface is at at (in annual bps unit)
The realized vol is (in annual bps unit)

Then the model fair volatility is , regardless how much time the
swap has seasoned.
In numerical implementation, this test case may not be recovered
exactly, but it is close. For a 6 month vol swap, 6% at vol surface
and 6% realized vol, taking 1000 strikes between the
automatically computed range, we recovered 6.0 0.0015% in
OG implementation for seasoned swap with various degree of
seasoning.
Diagnostic Outputs
Implementation Tests
Flat vol surface test
Other tests
We have also reproduced the numerical example for newly issued vol
swap given on Table B.1, Pg. 21 in Realized Volatility and Variance:
Options via Swaps.
Appendix
Demonstration of Correlation Immunity of the Vol
Swap Replicating Prole
The dening property of p
(z) that gives the replication of power

of variance:
This implies:
The BS delta of the Carr-Lee replicating European prole is 0,
therefore, the replication is neutral to the rst order:
For p
(z) :=
1
2

1
2
1 + 8z, then
E
t
e
zX
T
= e
zX
t
E
t
_
S
T
S
t
_
p
Return to Correlation Immunization

Appendix

of variance:
This implies:
v
: The lognormal density with parameters
_
v
2
, v
_
.
_

0
y
p
+
v
(y)dy =
_

0
y
p
v
(y)dy
Appendix

of variance:
This implies:
Using the above result, as well as the identity
+
p
+
+
= 0, we
have
F
BS
S
(S
t
) =
1
2
S=S
t
_

0
dy
v
(y)
_

0
dz
_
+
1 e
zX
t
_
Sy
S
t
_
p
+
z
3/2
+
1 e
zX
t
_
Sy
S
t
_
p
z
3/2
_
_
= 0

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Carr-Lee Method for Volatility Swap Valuation

OpenGamma Quantitative Research Group

Pays realized quadratic variation minus strike

The expected fair variance can be expressed as the PV of a log

European payoff proles may be replicated with European vanilla

This replication strategy is static in option positions.

Jensens inequality implies fair variance to be greater than the

Estimate the convexity adjustments: Does not directly give replicating

model free replication

exact for independent spot and vol process

rst order immune to spot and vol correlation

and put with strikes F

> K, where the realized

(z) switch from purely real to purely imaginary at

(z) switch from purely real to purely imaginary at

The vol surface is at at (in annual bps unit)

The realized vol is (in annual bps unit)

(z) that gives the replication of power

Return to Correlation Immunization

(z) that gives the replication of power

(z) that gives the replication of power

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