Lecture3.2010. Courseworks

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E4718 Spring 2010: Derman: Lecture 3:P&L, Hedging, Transactions Costs; The Smile: Constraints, Problems, Models
Lecture 3:
P&L, Hedging, Transactions Costs;
The Smile: Constraints, Problems, Models
Summary of Lecture 2
The Black-Scholes PDE is equivalent to setting the Sharpe ratios of the

option and the stock equal to each other, instantaneously.
S r
C r
--------------- = -------------C
S
Key insight is replication of risk; thats why there is only one Sharpe ratio.
Hedging Options Means Betting On Volatility

When you hedge at implied volatility, the net P&L of the hedged curved
1
2
2 2
position during time t = --- ( )S t
2
This P&L is path-dependent and random, and so although it is deterministic at each instant, the final P&L is unknown.
Hedging at (supposedly known) realized volatility r :The final P&L of a
hedged derivative V purchased at implied volatility and hedged at realized
volatility is V r V i , and known in advance if we know r , but the fluctuations in the P&L along the way are random.
The P&L of Hedged Trading Strategies

( C 0 0 S 0 )e
r(T t)
initial hedge
T r(T )
= ( CT T ST ) + e
final hedge
S [ d ] b
rebalancing
Next:
Hedging with any volatility
Discrete hedging error
Transactions costs
___________
The smile in various markets
The difficulties the smile presents for trading desks and for theorists
Pricing and hedging
How volatility varies; what people mean by volatility
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How to graph the smile?

Delta as a plotting parameter
Parametrizing options prices: delta, strike and their relationship
Estimating the effects of the smile on delta and on exotic options
Reasons for a smile
No-riskless-arbitrage bounds on the size of the smile
Fitting the smile
Black-Scholes is wrong: what can replace it?
Behavioral reasons for the smile
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3.1
\No
Matter How You Hedge
From Eq 2.24 of Lecture 2 gave another expression for the value of an option
in terms of rehedging:
T
C0 = CT e
r ( T t )
( S , ) [ dS S r d ]e
r ( t )
Here the LHS is the value of the option based on the hedging and the value of
the final payoff. And this is the formula for any delta one uses, not necessarily
the Black-Scholes delta.
Now, assume that = r and hence with GBM dS Srdt = SdZ
Then
T
C0 = CT e
r ( T t )
( S , ) [ S ]e
r ( t )
dZ
Now lets take expected values over all stochastic movements on the stock:
Then
E [ C 0 ] = E [ C T ]e
r ( T t )
where the expected value of the last term for each increment dZ is zero, of
course, since the mean of the Wiener process is zero.
The equation above is simply the Black-Scholes formula when you take the
expected value over the lognormal distribution of the stock price at expiration.
Thus irrespective of the hedge ratio, but provided that = r , the expected
value of the call is the discounted expected value of the payoff, no matter
how you hedge, no matter what hedging formula you use for delta, even if
you dont hedge at all.
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3.2
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The Effect of Different Hedging Strategies1
In the previous section, we hedge at each intermediate time between inception

and expiration by shorting i shares of stock. How should we have calculated
i using implied volatility or realized volatility? How do the return profiles
depend on the hedging strategy?
Realized (or actual) volatility is noisy, changing from moment to moment.
Implied volatility is a parameter, the markets expected volatility plus some
premium for other unknowns (hedging costs, inability to hedge perfectly,
uncertainty of future volatility, the chance to make a profit, etc.). Implied volatility is usually greater than realized volatility.
3.2.1 Hedging with Realized (Known) Volatility

Consider the idealized case where we know that the future realized volatility
will be greater than current implied volatility . How can we make money as
an options trader? We buy the option at its implied volatility and then hedge it
at the realized volatility (which we hypothetically know) in order to replicate
the option perfectly. Then the final P&L of this traded is
V ( S, , ) V ( S, , )
where V ( S, , ) is the value obtained by perfectly replicating the option at the
actual volatility, is the time to expiration, and for brevity we have suppressed
displaying the dependence of non-essential variables such as interest rates and
dividend yields. We will sometimes write V ( S, , ) as Vr (for realized) and
V ( S, , ) as Vi (for implied).
How Is This Known Profit Realized As The Stock Evolves Through Time?
Assume the stock evolves with actual drift and volatility , so that
dS = Sdt + SdZ .
Eq.3.1
where is not the riskless rate r, and the stock S pays a continuous dividend
yield D.
The Black-Scholes hedge ratio for a realized volatility r is given by
1. Ahmad, R. and Paul Wilmott, Which Free Lunch Would You Like Today, Sir?: Delta
hedging, volatility arbitrage and optimal positions. Wilmott Magazine.
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1
N ( x ) = ---------2
y 2
dy
SF r ( T t )
ln ----- -----------------------K
2
d 1, 2 = ----------------------------------------- Tt
= N ( d1 )
Here S F = S exp [ ( r D )t ] is the forward price of the stock, and depends on
the riskless interest rate r and the dividend yield D rather than .
In the table below we use the symbol V for a security with value V. Lets now
figure out our moment-to-moment P&L over time when we borrow money to
finance a long position in the security V and hedge it using the (assumed
known) realized volatility, and show that we eventually capture V r V i .
Table 1: Position Values when Hedging with Realized Volatility
Time
t
t + dt
Option Position, Value
Stock Position, Value
Vi , Vi
r S , r S
V i ( t + dt, S + dS ) ,
r S , r ( S + dS )
V i + dV i
Value of Cash Position
Net Position Value
r S Vi
( r S V i ) ( 1 + rdt )
( V i + dV i r ( S + dS ) )
r DSdt
( r S V i ) ( 1 + rdt )
dividends
paid
interest
received
r DSdt
Thus the change in the P&L in time dt is given by

dP&L = [ V i + dV i r ( S + dS ) ] + ( r S V i ) ( 1 + rdt ) r DSdt
= dV i r dS rdt ( V i r S ) r DSdt
Eq.3.2
But the Black-Scholes equation is equivalent to the statement that if we had

purchased the option at the fair future realized volatility r , then the change in
the value of the P&L while hedging with realized volatility would be zero, so
that replacing the subscript i by r in Equation 3.2 gives
0 = dV r r dS rdt ( V r r S ) r DSdt
which can be rewritten as
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r dS rdt ( r S ) r DSdt = rdtV r dV r
Eq.3.3
Substituting Equation 3.3 into the RHS of Equation 3.2 we obtain the P&L
generated between times t and t + dt:
dP&L = dV i dV r rdt ( V i V r )
rt
= e d[ e
rt
( Vi Vr ) ]
The present value of this profit is obtained by discounting to the initial time t0:
dPV(P&L) = e
r ( t t 0 ) rt
e d[e
rt
rt
( Vi Vr ) ] = e 0 d [ e
rt
( Vi Vr ) ]
Eq.3.4
By expressing the change in the P&L above in terms of total differential makes
it easy to integrate over the total life of the option, which leads to
T
PV(P&L) = e
rt 0
d[e
rt
( Vi Vr ) ]
t0
= 0 ( Vi Vr ) = Vr Vi
Eq.3.5
if T is expiration
where the integrand at time T is zero because at expiration the payoff of the
standard option is independent of volatility.
So we see that the final P&L at the expiration of the option is known and deterministic and equal to the difference in value between the option valued at realized and implied volatility, provided that we know the realized volatility and
that we can hedge continuously.
_____
How is this known P&L realized over time? We show below that the P&L,
while in sum total deterministic, has a stochastic component that vanishes only
as we reach expiration. This is somewhat analogous to the value of bond,
whose final payoff at expiration is known but whose present value varies with
interest rates.
We showed in Equation 3.2 that the change in the P&L after hedging with
implied volatility is given by
dP&L = dV i r dS rdt ( V i r S ) r DSdt
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We can use Itos Lemma to expand dV i and the Black-Scholes equation to

simplify the result. Applying Itos Lemma to the above equation for the actual
mark-to-market value of the P&L after a real move dS in time dt yields
2 2
1
dP&L = i dt + i dS + --- i S dt r dS rdt ( V i r S ) r DSdt
2
Eq.3.6
1
2 2
= i + --- i S dt + ( i r )dS rdt ( V i r S ) r DSdt
2
But the Black-Scholes equation for the option V valued at the implied volatility can be written as
1
2 2
i = --- i S + rV i ( r D )S i
2
Substituting for i in Equation 3.6, we obtain
1
2 2
2
dP&L = --- i S ( )dt + ( i r ) { ( r + D )Sdt + SdZ }
2
Eq.3.7
Thus, even though the total integrated P&L is deterministic, the increments in
the P&L when you hedge with random volatility have a random component
dZ . (Note that this is the non-discounted P&L, not its present value obtained
by discounting each increment to the P&L by the appropriate discount factor.
The total present value of the P&L should equal the difference in price between
the option valued at implied volatility and valued at realized volatility.
To illustrate this, here is a plot of the cumulative P&L along ten random stock
paths, each generated with a realized volatility different from that of implied
volatility.
r = 0.3
i = 0.2
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The accuracy with which the P&L converges to the known value depends on
how continuous the hedging is, of course. Our example uses 100 hedging steps
to expiration.
The final P&L is almost (but not quite) path-independent almost, because
100 rehedgings per year is not quite the same continuous hedging.
Here is a similar plot of the cumulative P&L when we rehedge 10,000 times,
i.e. almost continuously; then the final P&L is virtually independent of the
stock path.
3.2.2 Bounds on the P&L When Hedging at the Realized Volatility

Notice the upper and lower bounds that seem to define the boundaries of the
above figure. We can understand them as follows.
From Equation 3.4 the P&L of an option bought at implied volatility and
hedged at realized volatility is given by
dPV(P&L) = e
r ( t t 0 ) rt
e d[ e
rt
rt
( Vi Vr ) ] = e 0 d [ e
rt
( Vi Vr ) ]
We can integrate this from the inception of the position at time t 0 = 0 when
the stock price is S 0 to intermediate time t, stock price S , to obtain
PV ( P&L(t) ) = [ V ( , S, t ) V ( , S, t ) ] e
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rt
+ [ V ( , S 0, 0 ) V ( , S, 0 ) ]
Eq.3.8
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Suppose, as in the figure above, that > . Then the both terms in the square
brackets in Equation 3.8 are positive, because the standard options prices are
monotonic in volatility. Also, the second term is the value at inception, and
independent of the path. Therefore the upper bound occurs when the first term
is zero, which occurs at S = 0 or S = . The upper bound of the P&L is
therefore the constant value [ V ( , S 0, 0 ) V ( , S, 0 ) ] , corresponding roughly
to the heavy dotted blue line in the figure below.
The lower bound to the P&L is given by differentiating Equation 3.8 w.r.t. S
and setting the derivative equal to zero to find the minimum. It occurs at
S = Ke
bound
( r 0.5 ) ( T t )
Ke
r ( T t )
(assuming zero dividend rate), and leads to a lower
( ) T t
2N --------------------------------- 1 + [ V ( , S 0, 0 ) V ( , S, 0 ) ]
2
That value is represented roughly by the lower dotted blue line on the figure
above.
3.2.3 Hedging with Implied Volatility

When you hedge with implied volatility, the evolution of the P&L has no random dZ component, as we showed in our derivation of the hedged options
P&L in Lecture 2. In this case the final value of the P&L depends on the path
taken, and is not deterministic.
Suppose we buy the option at the implied volatility, hedge it at implied volatility, and any cash received in the bank to earn the riskless rate. Lets now figure
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out our moment-to-moment P&L. We denote a security with price V by the

symbol V .
Table 2: Position Values when Hedging with Implied Volatility

Time
t
t + dt
Vi , Vi
i S
V i , V i + dV i
i S , i ( S + dS )
Net Position Value
i S Vi
( i S V i ) ( 1 + rdt )
( V i + dV i i ( S + dS ) )
i DSdt
( i S V i ) ( 1 + rdt )
i DSdt
The change in the P&L in time dt is given by

dP&L = [ V i + dV i i ( S + dS ) ] + ( i S V i ) ( 1 + rdt ) i DSdt
= dV i i dS r ( V i i S )dt i DSdt
Eq.3.9
Using Itos lemma for dV i we obtain

1
2 2
dP&L = i dt + i dS + --- i S dt i dS r ( V i i S )dt i DSdt
2
1
2 2
= i + --- i S + ( r D ) i S rV i dt
2
But the Black-Scholes equation for the option valued at implied volatility
states that
1
2 2
i + --- i S + ( r D ) i S rV i = 0
2
Substituting for i from the last equation into the previous one, we obtain
1
2 2
2
dP&L = --- i S ( )dt
2
Eq.3.10
The present value of this profit is obtained by discounting to the initial time t0,
and then integrating, we obtain
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1
2 2
2 r ( t t0 )
P&L = --- i S ( )e
dt
2
Eq.3.11
t0
2
The P&L depends upon the value of i S along the path to expiration, and this
factor, especially i which varies exponentially with ln S K , is highly pathdependent. Although the hedging strategy captures a value proportional to
2
( ) , the coefficient will be close to zero if the option is far in or out of

the money when the proportionality constant is small, and therefore the hedging strategy will be insensitive to volatility in those regions.
Below is a plot of the cumulative P&L along ten random stock paths generated
with a realized volatility different from that of implied volatility. Because we
hedge using implied volatility, the P&L depends upon the path taken. Our
example uses 100 hedging steps to expiration and a stock drift of 10%.
growth = 10%
On the next page is a similar example where the stock growth rate is much
larger (100%); with this drift the stock price is much more likely to move out
of the money, with the -factor on average becoming much smaller. The average cumulative P&L captured is therefore appreciably lower, as displayed on
the plot.
The above hedging strategies, using realized or implied volatilities, are of
course somewhat idealized. In practice, realized volatility isnt know and keeps
changing, and so you cannot hedge at the known realized volatility. A trading
desk would most likely hedge at the constantly varying implied volatility
which would move in synchronization with (but not be exactly equal to) the
recent realized volatility. because, among other reasons, realized volatility is
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growth = 100%
instantaneous and implied volatility looks far into the future. One could simulate this by making a model of the relation between implieds and their response
to realizeds.
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3.3 Hedging at an Arbitrary Constant Volatility

Suppose, for the more general case, we buy an option at an implied volatility
and hedge it to expiration at a volatility h , the chosen hedge volatility, while
realized volatility remains constant at r . Here is the computation of the
change in P&L over a time dt:
Table 3: Position Values when Hedging with an Arbitrary Volatility
Time
t
t + dt
Vi , Vi
h S
V i , V i + dV i
h S ,
Net Position Value

0
h S Vi =
( h S Vh ) + ( Vh Vi )
h ( S + dS )
( h S V i ) ( 1 + rdt )
( V i + dV i h ( S + dS ) )
h DSdt
( h S V i ) ( 1 + rdt )
h DSdt
The P&L is given by

dP&L = dV i h dS h SDdt + { ( h S V h ) + ( V h V i ) }rdt
= dV h h dS h SDdt + ( dV i dV h ) + { ( h S V h ) + ( V h V i ) }rdt
1
2 2
= h + --- h S r + ( r D )S h rV h dt + ( dV i dV h ) + ( V h V i )rdt
2
Now the Black-Scholes solution with the hedge volatility satisfies the p.d.e.
1
2 2
h + ( r D )S h + --- h S h rV h = 0
2
Substituting this last equation into the previous one, we obtain
1
2
2
2
dP&L = --- h S ( r h )dt + ( dV i dV h ) + ( V h V i )rdt
2
1
2
2
2
rt
rt
= --- h S ( r h )dt + e d { e ( V i V h ) }
2
Taking present values at time t 0 leads to
dPV ( P&L ) = e
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r ( t t0 ) 1
rt
--- h S ( r h )dt + e 0 d { e
2
rt
( Vi Vh ) }
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The present value of the P&L at time t 0 is then given by

T
1 r ( t t0 )
2
2
2
PV ( P&L ) = V h V i + --- e
h S ( r h )dt
2
Eq.3.12
t0
where V h and V i have equal values at expiration. Note that in the limit that the
hedge volatility h is set equal to either the realized volatility r or the
implied volatility i , Equation 3.12 reduces to our previous results.
3.3.1 The Maximum P&L When Hedging With An Arbitrary

Volatility
What can we deduce about the behavior of the P&L in Equation 3.12? For
r > h , the minimum is clearly V h V i . The maximum occurs when the
2
path-dependent term S h is a maximum along the entire path. Now

D
SN' ( d 1 )e
S h = -----------------------------h
2
Eq.3.13
where
2
1 d 2
N' ( d 1 ) = ----------e 1
2
and d 1 depends on h .
The maximum occurs when
D
SN' ( d 1 )e
d1
N' ( d 1 )e
2
( S ) = -------------------------- ------------------------------ ---------------- = 0
S
h
h
S h
or
2
ln ( S K ) + ( r D ) + 0.5 h
d1
1 = ------------- ------------------------------------------------------------------------2
h
h
which has the solution
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S = Ke
( r D h 2 )
Eq.3.14
At this value of S, in Equation 3.13

r
Ke
S h = ----------------------- h 2
2
Eq.3.15
Taking the path for the evolution of the stock that moves along this value of S ,
we maximize the P&L. By combining Equation 3.12 and Equation 3.15, we
obtain
T
r ( T t )
r ( t t 0 ) Ke
1 2
2
maxPV ( P&L ) = V h V i + --- ( r h ) e
--------------------------------dt
2
T t 2
t0
2 r ( T t0 )
h )e
Eq.3.16
T t0
K ( r
= V h V i + -------------------------------------------------------------------2 h
The last term is approximately twice the difference in value of an atm option at
volatility h and an atm option at r .
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3.4 Expected Profit after Hedging at Implied

Volatility
From Equation 3.11 in the previous lecture we have the P&L when hedging at
implied volatility:
T
1
2 2
2 r ( t t0 )
P&L = --- i S ( )e
dt
2
t0
where we denote the realized volatility by .

This integral is path-dependent, so lets find the mean P&L over all paths. Its
possible with some difficulty to take this average analytically over all stochastic paths for the stock price; this is similar to valuing a path-dependent option,
for example an option on the average of the stock price. You can write down a
PDE for it and try to solve it, as illustrated in Wilmotts paper.
Its easier, however, to write a Monte-Carlo program to evaluate the average
P&L over all paths. Shown below is the expected P&L (blue line) over all
paths for an option bought and hedged at an implied volatility of 0.2 when realized volatility is 0.4, for a range of different stock growth rates . The green
line shows the standard deviation of the P&L. You can see, roughly, that the
expected P&L is a maximum when the growth rate is such that the stock is
close to at-the-money at expiration, so that its is largest. From Equation 3.14
2
this occurs when = r D 0.5 i = 0.05 0.5 ( 0.2 ) = 0.03 , which corresponds roughly to the value of at the maximum in this illustration. The red
line shows the P&L obtained by hedging at realized volatility, and is just equal
to the difference between the price of the option at realized volatility and the
price of the option at implied volatility. This value is fairly close to the maximum expected P&L when the option is hedged at implied volatility.
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3.5 Hedging Errors from Discrete Hedging

3.5.1 A Simulation Approach
In the real world you cannot hedge continuously, and therefore it is important
to understand the errors that creep into your P&L when you hedge at discrete
intervals. Some traders hedge at regularly spaced time intervals; others hedge
whenever the delta changes by more than a certain amount. In what follows
here we will discuss hedging at regular time intervals.
Below we show the results of carrying out a Monte Carlo simulation, re-hedging or rebalancing to zero net delta at equally spaced intervals. Consider the
case where the time to expiration is 1 month, the realized volatility is 20%,
with the growth rate of the non-dividend-paying stock equal to the riskless
interest rate, so that = r = 0.05 . Now lets examine an at-the- money
option hedged at an implied volatility of 20% equal to the realized volatility.
21steps
vol = 20%
zero rates
21 Rehedgings, Std. deviation. = 0.42
84 steps
vol = 20%
zero rates
84 Rehedgings, Std. deviation. = 0.21
Note that the mean P&L is zero and that when we quadruple the number of
hedgings, the standard deviation of the P&L halves. We will find the explanation for this a little later.
Now lets see what happens if the implied volatility differs from realized volatility. Choose an implied volatility of 40% as the hedging volatility, that is, as
the volatility used to calculate the value of .
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no reduction in variance with increasing rehedges unless hedge vol = realized vol
In the figure above we now see that the distribution looks similar, but there is
no longer the same reduction in standard deviation when the number of rebalancings quadruple. Both distributions are more or less symmetric though.
Finally lets see what happens when the drift is not the same as the riskless
rate, even though implied/hedging) and the realized volatility are both set equal
to 0.2. Here we see that the standard deviation of the P&L still halves as the
number of rehedgings doubles.
imp = real
mu > r
21 steps
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imp = real
mu > r
84 steps
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Finally, for completeness, we look at the where implied is not equal to realized
volatility and r . In this case the distribution is very asymmetric.
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3.5.2 Understanding Hedging Error Analytically

Here we assume that implied and realized volatility are identical.
S
------- = t + t
Suppose in discrete time S
N ( 0, 1 )
The delta-hedged option portfolio is given by
C
= C S
S
Eq.3.17
The hedging error accumulated over time t due to the mismatch between a
continuous hedge ratio and discrete time step is given by
HE = + d e
rt
= d rdt
2 2 2
S
C
C t t + C S dS + C SS ----------------- t C S dS rt C S
2
S
2 2 2
S
C
C t + C SS ----------------- r C S t
2
S
Now from the Black-Scholes equation, the last term in the square brackets is
given by
2 2
C
S
r C S = C t + C SS ----------S
2
and so the C t term cancels, and for one step t
1
2 2 2
HE = --- C S ( 1 )t
2 SS
Eq.3.18
Now for a normal variable E ( ) = 1 and so the expected value of the hedg2
ing error is zero, with a distribution.

Over n steps to expiration, the total HE is
n
HE =
2 2
--2- i Si i ( i
1 )t
Eq.3.19
i=1
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The variance of the hedging error can be approximately calculated and shown
to be
n
2
HE
2
1
2 2 2
= E --- [ i S i ] ( i t )
2
Eq.3.20
i=1
One can show by integration that contingent on an initial stock price S0 the
expected value when the option is close to at the money is roughly given by
2
T
2 2
4 2
E [ i S i ] = S 0 0 --------------2
2
T ti
Thus for constant volatility
n
2
HE
2
1
T
2
4 2
= --- S 0 0 --------------(
t
)
2
2
2
T ti
i=1
2 1 T
2
4 2
( S 0 0 ) ( t ) --------2t t
T
d
---------------2
2
T
2 T
2
4 2
= ( S 0 0 ) ( t ) --------4t
2
2
2
= --- n ( S 0 0 t )
4
1 C
2
Now S 0 0 = ------------------- from Black-Scholes, where T t is the time to expi(T t)
ration, so that we can write
2
1 C 2
1 C 2
C 2
2
HE = --- n ------------------- t = --- n --- = ------
4 (T t)
4 n
4n
since ( T t ) ( t ) = n , so that
C
HE --- ------4 n
Thus, the hedging error is approximately
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Eq.3.21
C
------- . What does this mean?
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3.5.3 Understanding The Results Intuitively

Hedging discretely rather than continuously introduces uncertainty in the
hedging outcome but does not bias the final profit/loss -- the expected value is
zero.
Simple analytic rule for the standard deviation of P&L
C
------
n
For an option struck close to spot, there is a simpler version of the rule
P&L
--------------------------------------- -----fair option value

4n
Thus, approximately, quadrupling the number of hedges halves the hedging
error, as we saw in the simulation results in the previous section.
The way to understand this formula is to realize that volatility itself, when
measured or sampled discretely, is uncertain.
The standard deviation of a constant volatility measured discretely is ---------2n

You can think of this as being due to statistical sampling error.
This is quite a large error, and here we have assumed we know the future volatility with certainty. Imagine the error when you dont even know future volatility and therefore your hedge ratio is incorrect not just because it is
discontinuous, but because you dont know the appropriate volatility to use.
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3.6 The Effect of Transactions Costs

3.6.1 Simulation
Suppose it costs money to buy and sell the stock each time you rehedge. Then,
not only is the P&L uncertain because of the discrete hedging schedule and the
consequent inaccuracy of the hedge ratio, but in addition the cost of hedging
also lowers the fair value of the option if you buy it, and raises the cost to you
if you sell it.
In the examples that follow, we assume a simple transactions cost proportional
to the cost of the shares traded, and hedge at the realized volatility.
Rehedging at regular intervals
You can rehedge at every step, no matter how little or how much stock you
need to trade to rebalance.
fair price = $8
100 rehedgings,
lose $1,
std. dev, 0.44
0.1% trans cost
10 rehedgings
lose $0.16
std dev 2.1
0.1% trans cost
Notice that logically, the more frequently you rehedge, the more accurately you
replicate the option; however, the more you rehedge the more of your profit
you give away to transactions costs. Correspondingly the less you rehedge, the
less profit you relinquish; but, correspondingly, the less certain that profit is.
When you hedge in practice, you might want to figure out the optimal hedge
ratio.
Rehedging triggered by changes in the hedge ratio
Another way to rehedge more efficiently is to trigger the rehedging on a substantial change in delta; you only rehedge when there is a big change in the
hedge ratio. This is a more sensible means of hedging, but the computation
converges more slowly. Here is an example of hedging an at-the-money call
with a delta trigger of 0.02 or 2% and a transactions cost of 0.1%.
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2% delta trigger
0.1% trans cost
202 hedges
-0.63 loss
std dev 0.38
better profit
less variation
Comparing this to the similar case where you rehedge at every step over 1000
steps, we see that the loss owing to the transactions cost is smaller, and the
standard deviation of the P&L is smaller too.
Here is the option being rehedged only when the delta changes by 50 percentage points and with a transactions cost of 1%.
50% delta trigger

1% transactions cost
Rehedge once half the time

Then loss in value is
~0.5(dDelta.S.k)
~0.5(0.5x100x0.01)
~0.25
The distribution is bimodal. The reason is that if you rehedge only when the
delta of the option changes by 50 points, then rehedges only occur when the
stock makes a substantial move up or down in order to achieve such a large
change in the delta. Hence one set of final call prices involve no transactions
costs (over the paths where delta changed by less than 50 points) and hence lie
above the mean; the other set of call final call prices involve one rehedging and
its cost (over the paths where delta did change by 50bp or more) and hence lie
below the mean.
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3.6.2 Analytical Approximations to Transactions Cost

Read this section to educate yourself, but we probably wont cover it in class.
In Lecture 2 we showed that the hedging error when the hedge volatility and
the realized volatility are identical is given by
n
HE =
2 2
--2- i Si i ( i
1 )t
Eq.3.22
i=1
To leading order in t , the mean of the hedging error is zero, and the variance
2
is O ( [ t ] ) . If the option has time T to expiration, then the total number of

rehedgings is T ( t ) , so that the variance in the hedging error is
2
[ t ]
O T
- = o ( Tt ) O which vanishes as t 0 . Hedging continuously
--------------t
captures exactly the value of the option.
Now lets see what happens when you include transactions costs. To make
things simple, lets consider the case where every time you trade the stock
(buying or selling), you pay a fraction k of the cost of the shares traded.
Assume that you rehedge an option C with value C every time t passes.
Then, every time you rehedge, you have to trade a number of shares equal to
2
( S + S, t + t ) ( S, t )
C
S
Then the cost of this rebalancing is the value of number of shares traded times
the fraction k, that is
2
C
S
S ( kS )
where the absolute value reflects the fact that you pay a positive transaction
cost irrespective of whether you buy or sell shares.
If S = St + S t , then to order ( t )
in time t is
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the expected transactions cost
Lecture3.2010.fm
Page 27 of 42
C
S
S tk
Since the expected value of is not zero, the expected hedging cost in time
t is non-zero too. For an option with time to expiration T, there are T ( t )
T
1
rehedgings, so that the total cost of rehedging is of order ----- t --------- as
t
t
the time between rehedgings goes to zero.
3.6.3 A PDE Model of Transactions Costs

One can approach transactions costs even more analytically in the framework
of Hoggard, Whaley & Wilmott (see Wilmotts book Derivatives.)
Let
dS = Sdt + S dt
where is drawn from a standard normal distribution. From Lecture 2, the
P&L of a hedged position when one includes transactions costs is given by
dP&L = dV dS cash spent on transactions costs
2
V
V
1 2 2 V 2
dt + dS + --- S
=
Z dt dS S N
2
t
S
2
S
2
V
V
1 2 2 V 2
Z dt S N
=
dt + ( Sdt + SZ dt ) + --- S
2
t
S
2
S
2
1 2 2 V 2
V
V
V
= SZ dt + --- S
Z + S + dt S N
2
S
t
S
2
S
where we have set the dividend yield D and the riskless rate r to zero, N is the
number of shares traded to rehedge the initially riskless portfolio at the next
interval, and the modulus sign reflects the fact that transactions costs are paid
for both buying and selling shares.
Now we hedge the initial portfolio by choosing as usual =
V ( S, t ) . After
S
time t we have to rehedge, so that
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N ( S, t ) =
V ( S + S, t + t ) V ( S, t )
S
S
2
V
S
V
S
SZ t
to leading order in t , and notice that N itself is stochastic and related to of

course. Our hedge is not a perfect riskless hedge.
Approximately, therefore, the average number of shares traded is
2
E [ N ] V SE Z
2
S
2
--- V S t
2
S
t =
with an average transactions cost obtained by multiplying the above by the cost
S per share, to yield the cost
2
2 V
2
--- 2 S t
S
The expected value of the change in the P&L is therefore given by
2
1 2 2 V 2 V
2 V
2
dE [ P&L ] = E --- S
Z
+
------S
dt
2
t
t S 2
2
S
2
1 2 2 V 2 V
2 V
2
--- S
Z
+
S
------ dt
2
t
t S 2
2
S
This isnt riskless, but rather stochastic. We are going to assume, as does Wilmott, that even though the portfolio isnt riskless, the holder of this not-quitehedged portfolio would expect to earn the riskless rate. In that case, since the
value of the hedged portfolio is V S
V
, the expected value of the portfolio a
S
V
time dt later should be r V S dt .
S
Inserting this expression into the LHS of the equation above leads to the equation
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Page 29 of 42
V 1 2 2 V 2
2
V
2
+ --- S
Z -------- V S + rS rV = 0
2
t 2
S
t 2
S
S
Eq.3.23
This is a modification of the Black-Scholes partial differential equation with a

2
nonlinear additional term proportional to the absolute value of =
.
2
S
Because of the nonlinearity, the sum of two solutions to the equation is not necessarily a solution too; you cannot assume that the transactions costs for a portfolio of options is the sum of the transactions costs for hedging each option in
isolation.
2
For a single long position in a call or a put,
V
S
0 , so we can drop the modu-
lus sign. Equation 3.23 then becomes

2
V 1 2 2 V 2
V
+ --- S
Z + rS rV = 0
2
t 2
S
S
Eq.3.24
where
2
2
2
= 2 -------t
This is the Black-Scholes equation with a modified reduced volatility, first

derived by Leland, and the option is worth less. If you are long, you must pay
less than the fair BS value since the hedging will cost you. For a short position,
the effective volatility is enhanced, given by
2
2
2
= + 2 -------t
When you sell the option you must ask for money because hedging it is going
to cost you.
The effective volatility is
2
-------t
Eq.3.25
For very small t this expression diverges and the approximation becomes
invalid.
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3.7 More About The Smile

The Columbia Smile Generated by a Truck with Stochastic Volatility in
2004
3.7.1 Equity index smiles: a reminder

Since the 87 crash there has been a persistent skewed structure in BlackScholes implied volatilities in most world equity option markets.
Representative implied volatility skews of S&P 500 options. (a) Pre-crash. (b)
Post-crash. Data taken from M. Rubinstein, Implied Binomial Trees J. of
Finance, 69 (1994) pp. 771-818.
(a)
Pre-crash
20
V olatility
18
16
14
0.95
0.975
Post-crash
20
1.025
Strike/Index
1.05
18
16
14
0.95
0.975
1.025
1.05
Strike/Index
The Black-Scholes model assumes that volatility is independent of strike and

time to expiration. But the Black-Scholes model has no simple way of allowing
the implied volatility of the stock to depend upon the option strike or time. The
stocks volatility cannot be influenced by the option whose price you quote.
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Here is an old but typical S&P smiles plotted against strike K.
S&P
September 27,
1995.
Strike
Oct. 1 2007
Jan. 24 2008
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short-term implieds
move more
than long-term
negative correlation
during crisis
From Fenglers book
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FIGURE 3.1. Implied Volatility as a Function of Strike/Spot for Different

Expirations. (Crash-o-phobia: A Domestic Fear Or A Worldwide Concern?
Foresi & Wu JOD Winter 05
The quoting convention is the Black-Scholes implied volatility

EXHIBIT 2
Implied Volatility Smirk on Major Equity Indexes
20
T
A
M
28
26
FO
R
25
30
24
22
20
18
Average Implied Volatility, %
30
14
85
90
95
100
105
110
115
120
80
85
90
SixMonth Options
22
20
16
26
24
22
20
90
95
100
105
110
115
TH
85
14
80
120
28
O
R
EP
22
20
18
85
90
95
100
95
100
105
110
115
120
115
120
Strike in Percentage of Spot
30
30
24
90
ThreeYear Options
TwoYear Options
26
85
28
26
24
22
20
18
105
110
115
120
80
85
90
95
100
105
110
FourYear Options
FiveYear Options
32
LE
30
26
IL
IS
120
18
16
14
115
28
IS
18
24
22
20
18
80
120
TI
24
28
115
26
30
110
28
80
105
LE
30
30
80
100
OneYear Options
32
16
IT
95
IN
80
16
15
The slope of
implied volatility
against strike as a
percentage of spot
is negative, even
for long maturities, though not as
steep as for short
maturities.
35
TO
out-of-the-money
puts have higher
implied BlackScholes volatilities than out-ofthe-money calls.
(Why?)
ThreeMonth Options
34
32
OneMonth Options
40
Notice the patterns

that persist across all
indexes:
28
26
24
22
20
18
85
90
95
100
105
110
115
120
80
85
90
95
100
105
110
Lines represent the sample averages of the implied volatility quotes plotted against the xed moneyness levels dened as strike prices as percentages of the spot level. Different panels are for options at different maturities. Data are daily from May 31, 1995, to May 31, 2005, spanning
2,520 business days for each series. The 12 lines in each panel represent the 12 equity indexes listed in Exhibit 1.
2/7/10
Lecture3.2010.fm
Moneyness, d
NKY
Moneyness, d
FTS
Moneyness, d
AEX
L
A
TO
25
26
27
28
29
30
31
32
33
34
35
25
26
27
28
29
30
31
32
33
34
14
16
18
20
22
24
Moneyness, d
E
C
U
D
OMX
Moneyness, d
HSI
Moneyness, d
PR
E
R
2
short maturity
long maturity
ALO
18
20
22
24
26
28
30
IS
TH
20
3
22
24
26
28
30
32
20
22
24
26
28
30
32
34
Moneyness, d
SMI
Moneyness, d
LE
C
I
T
R
IBE
Moneyness, d
CAC
16
18
20
22
24
26
28
30
32
22
24
26
28
30
32
IN
20
3
25
30
35
Moneyness, d
SPX
Moneyness, d
MIB
Moneyness, d
Y
N
G
E
L
T
A
R
O
F
DAX
Lines denote the sample averages of the implied volatility quotes, plotted against a standard measure of moneyness d = ln(K/S)/( ) where
K, S, and denote the strike price, the spot index level, and the time to maturity in years, respectively. The term represents a mean volatility
level for each equity index, proxied by the sample average of the implied volatility quotes underlying each equity index. For each equity index,
we plot the implied volatility smirks at the 8 different maturities in the same panel. The maturities for each line are 1 month, 3 months, 6
months, 1 year, 2 years, 3 years, 4 years, and 5 years. The length of the line shrinks with increasing maturity, with the longest line representing
the shortest maturity (1 month). The 12 panels correspond to the 12 equity indexes.
22
23
24
25
26
27
28
29
30
31
32
16
18
20
22
24
26
28
30
32
24
26
28
30
32
34
36
38
40
Maturity Pattern of Implied Volatility Smirks




2/7/10
EXHIBIT 3
Page 34 of 42
Strike
FIGURE 3.2. Implied Volatility as a Function of log -------------- ( )
Spot
related to d1
When plotted against the number of standard deviations between the log of the
strike and the log of the spot price for a lognormal process, the slope of the
skew actually increases with expiration. Whatever is happening to cause this
doesnt fade away with future time.
Lecture3.2010.fm
Page 35 of 42
FIGURE 3.3. Behavior of implied volatility level c 0 as a function of option

expiration.
c0
0.3
Sample Average
Sample Average
0.28
0.26
0.24
0.22
term structure of
implied volatility is
roughly flat
0.2
0.18
0.16
0.5
1.5
2.5
3.5
4.5
Maturity in Years
c0
0.16
volatility of volatility
decreases with expiration,
suggesting mean reversion
or stationarity for the
instantaneous volatility
evolution
Standard Deviation
0.14
0.12
0.1
0.08
0.06
0.04
0.5
1.5
2.5
3.5
4.5
Maturity in Years
c
0
daily autocorrelation of
implied volatility is large,
and larger for longer
maturities
[excitement or depression
tends to continue]
0.998
0.996
Autocorrelation
0.994
0.992
0.99
0.988
0.986
0.984
0.98
0.978
1
1.5
2.5
3.5
4.5
Maturity in Years
0.5
EP
0.982
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R
EP
FIGURE 3.4. The cross-correlation between volatility level and slope of the skew
is large.
EXHIBIT 5
TO
Cross Correlations between Volatility Level and Smirk Slope

0
0.4
IL
LE
G
A
L
0.1
0.2
0
0.2
Corr( c , c )
0 1
Corr(c ,c )
0.3
0.2
0.4
0.5
IS
0.6
0.7
0.4
IT
0.6
0.8
0.8
0.9
0.5
1.5
2.5
Maturity in Years
3.5
4.5
0.5
1.5
2.5
3.5
4.5
Maturity in Years
Lines denote the cross-correlation estimates between the volatility level proxy (c0) and the volatility smirk slope proxy (c1). The left panel measures the correlation based on daily estimates, the right panel measures the correlation based on daily changes of the estimates.
short-term slope tends to get more negative as volatility increases
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3.7.2 Some characteristics of the equity implied volatility smile
2/7/10
Volatilities are steepest for small expirations as a function of strike, shallower for longer expirations.
The minimum volatility as a function of strike occurs near atm strikes o

strikes corresponding to slightly otm call options.
Low strike volatilities are usually higher than high-strike volatilities, but
high strike volatilities can also increase.
The term structure can slope up or down.
The volatility of implied volatility is greatest for short maturities, as with

Treasury rates.
There is a negative correlation between changes in implied atm volatility

and changes in the underlying asset itself. [Fengler: = 0.32 for the
DAX in the late 90s, for three-month expirations.]
Implied volatility appears to be mean reverting with a life of about 60 days.
Implied volatility tends to rise fast and decline slowly.
Shocks across the surface are highly correlated. There are a small number
of principal components or driving factors. Well study these effects more
closely later in the course.
Implied volatility is usually greater than recent historical volatility.
Lecture3.2010.fm
Page 38 of 42
3.7.3 Different Smiles in Different Markets

Here are some smiles for the S&P 500, plotted a little differently:
one year:
slope ~ 5 volatility pt. per 25% change in strike
Indexes generally have a negative skew. The slope here for a one-year option is
0.05
of order 5 volatility points per 250 S&P points, or about ---------- = 0.0002 . Note
250
that the slope for a 3-month option is about twice as much, which roughly con( ln K S )
firms the idea that the smile depends on --------------------- , because a four-fold
( )
decrease in time to expiration then implied a doubling of the slope of the smile.
The magnitude of the slope of the one-month option volatility is about 23 volatility points per 250 S&P points, or about 0.001.
3.7.4 Single stock smiles

A single stock smile is more of an actual smile with both sides turning up.
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3.7.5 Some currency smiles....

MXN/USD
USD/EUR
JPY/USD
weak
USD
strong Euro
strong
USD
weak peso
ATM Strike = 0.90
9.85
123.67
The smiles are more symmetric for equally powerful currencies, less so for
unequal ones. Equally powerful currencies are likely to move up or down.
There are investors for whom a move down in the dollar is painful, but there
are investors for whom a move down in the yen, i.e. up in the dollar, is equally
painful. Hence, there is a motive for symmetry. FX smiles tend to be more
symmetric and resemble a real smile.
Equity index smiles tend to be skewed to the downside. The big painful move
for an index is a downward move, and needs the most protection. Upward
moves hurt almost no-one. An option on index vs. cash is very different and
much more asymmetric than an option on JPY vs. USD.
Single-stock smiles tend to be more symmetric than index smiles. Single stock
prices can move dramatically up or down. Indexes like the S&P when they
move dramatically, move down.
Interest-rate or swaption volatility, which we will not consider much in this
course, tend to be more skewed and less symmetric, with higher implied volatilities corresponding to lower interest rate strikes. This can be partially understood by the tendency of interest rates to move normally rather than
lognormally as rates get low.
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3.7.6 Variation of implied volatility and the smile over time

Example: here is the behavior of volatility itself as time passes.
Three-Month Implied Volatilities of SPX Options
65
60
55
50
1200
1150
1100
1050
1000
950
900
850
800
750
700
650
S&P
45
40
35
30
at-the-money volatility
25
20
Why do traders talk

most about atm volatility?
ATM
11-02-98
10-01-98
09-01-98
08-03-98
07-01-98
06-01-98
05-01-98
04-01-98
03-02-98
02-02-98
01-02-98
12-01-97
11-03-97
10-01-97
09-01-97
15
INDEX
Here volatility goes up as the index goes down, and vice versa, but the volatility plotted is the at-the-money volatility ( S, t, S, T ) which is the implied
volatility of a different option each day, because as the index level S changes
the atm strike level changes. ATM volatility is therefore not the volatility of a
particular option you own.
If the indexs negative smile doesnt move as time passes and the index level
changes, then at-the-money volatility will go up when the index goes down
simply because the atm strike moves down with index level, and lower strikes
have higher implied volatilities. Thus, some of the apparent correlation in the
figure above would occur even if ( S, t, K, T ) didnt change with S at all.
How much of the correlation is true co-movement and not incidental?
A NOTE ABOUT FIGURES OF SPEECH: People in the market often talk
about how volatility changed. One must be very careful in speaking about
volatility because there are so many different kinds of volatility. There is realized volatility , at-the-money volatility, and implied volatility for a definite
strike K and tenor T - t, = ( S, t ;K, T ) which can vary with S,t and K,T.
When you talk about the change in , what are you keeping fixed?
For example, at-the-money volatility is atm = ( S, t ;S, T ) which constrains
strike to equal spot. When you talk about how this moves, its a very different
quantity from volatility of an option with a fixed strike. Its a little like the difference between talking about the yield of the 2016 bond and the yield of the
ten-year constant maturity bond over time. Those are different things: one ages
and the other doesnt.
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The index skews variation with time and with market level
SPX One-Month Skew By Delta

10
1400
1200
25D Put - ATM Vol
1000
6
800
4
25D-50D
SPX
600
2
400
0
200
05/04/99
03/16/99
01/26/99
12/08/98
10/20/98
09/01/98
07/14/98
05/26/98
04/07/98
02/17/98
12/30/97
11/11/97
09/23/97
08/05/97
06/17/97
04/29/97
03/11/97
01/21/97
12/03/96
10/15/96
08/27/96
07/09/96
05/21/96
04/02/96
02/13/96
12/26/95
11/07/95
09/19/95
08/01/95
06/13/95
04/25/95
03/07/95
01/17/95
11/29/94
10/11/94
08/23/94
0
07/05/94
05/17/94
-2
Date
Page 1
More recently, notice how skew varies with atm implied volatility.
S&P atm implied vol and risk reversal
between
25 delta call and
-25 delta put
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Page 42 of 42
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Page 1 of 42

The Black-Scholes PDE is equivalent to setting the Sharpe ratios of the

Hedging Options Means Betting On Volatility

The P&L of Hedged Trading Strategies

How to graph the smile?

Matter How You Hedge

The Effect of Different Hedging Strategies1

In the previous section, we hedge at each intermediate time between inception

3.2.1 Hedging with Realized (Known) Volatility

Option Position, Value

Stock Position, Value

Value of Cash Position

Net Position Value

Thus the change in the P&L in time dt is given by

But the Black-Scholes equation is equivalent to the statement that if we had

r dS rdt ( r S ) r DSdt = rdtV r dV r

We can use Itos Lemma to expand dV i and the Black-Scholes equation to

3.2.2 Bounds on the P&L When Hedging at the Realized Volatility

(assuming zero dividend rate), and leads to a lower

3.2.3 Hedging with Implied Volatility

out our moment-to-moment P&L. We denote a security with price V by the

Table 2: Position Values when Hedging with Implied Volatility

Option Position, Value

Stock Position, Value

Value of Cash Position

Net Position Value

The change in the P&L in time dt is given by

Using Itos lemma for dV i we obtain

( ) , the coefficient will be close to zero if the option is far in or out of

3.3 Hedging at an Arbitrary Constant Volatility

Option Position, Value

Stock Position, Value

Value of Cash Position

Net Position Value

The P&L is given by

The present value of the P&L at time t 0 is then given by

3.3.1 The Maximum P&L When Hedging With An Arbitrary

path-dependent term S h is a maximum along the entire path. Now

At this value of S, in Equation 3.13

3.4 Expected Profit after Hedging at Implied

where we denote the realized volatility by .

3.5 Hedging Errors from Discrete Hedging

21 Rehedgings, Std. deviation. = 0.42

84 Rehedgings, Std. deviation. = 0.21

3.5.2 Understanding Hedging Error Analytically

ing error is zero, with a distribution.

3.5.3 Understanding The Results Intuitively

--------------------------------------- -----fair option value

The standard deviation of a constant volatility measured discretely is ---------2n

3.6 The Effect of Transactions Costs

50% delta trigger

Rehedge once half the time

3.6.2 Analytical Approximations to Transactions Cost

is O ( [ t ] ) . If the option has time T to expiration, then the total number of

the expected transactions cost

3.6.3 A PDE Model of Transactions Costs

time t we have to rehedge, so that

to leading order in t , and notice that N itself is stochastic and related to of

This is a modification of the Black-Scholes partial differential equation with a

nonlinear additional term proportional to the absolute value of =

For a single long position in a call or a put,

0 , so we can drop the modu-

lus sign. Equation 3.23 then becomes