Investment Banking

Global Quantitative Research

A new approach to volatility skew

Osaka University, 1 December 2005

Toshinao AKUZAWA
Financial & Economic Research Center
Nomura Securities Co., Ltd.
This report represents only the personal opinion of the author.

1
 Outline of this talk
I. Overview of local volatility models
II. Markov-functional model for interest rate derivatives
III. Markov-functional skew model
IV. Discussion and numerical results

2
 volatility surface
a map
z from strike and maturity
z to market implied volatility (IV) of European call/put option
Typically, market IV varies with strike. (volatility skew / smile)
typical volatility of Nikkei 225

20%
19%
18%
17%
16%
Log-normal diffusion with volatility 15%

space invariant volatility 14%

13%
does not explain volatility skew. 12% 1.9
11% 1.2
10% maturity
0.4

80%
85%
90%
95%
100%
105%
0.1

110%
115%
120%
strike

3
 note on volatility surface
z Usually, a limited number of market prices is available.
z Many LV models require a complete information of volatility
surface.
z A naive application of linear or spline interpolation may lead to a
surface with arbitrage opportunity.
z We can apply Fengler’s method to construct an arbitrage-free
volatility surface which uses smoothing spline.

4
 Stochastic volatility (SV) models
examples
zHeston model
dSt
= (rt − q)dt + Vt dBt1
St
dVt = −λ (Vt − v )dt + η Vt dBt2
(B ), (B ): standard Brownian motion under risk - neutral measure
1
t t
2

d Bt1 , Bt2 = ρdt

zHeston model with jump in stock price

zHeston model with jump in stock price and variance

„described by a small number of parameters

„perfect fit to volatility surface is impossible
„requires two factors (price and volatility)

5
 Local volatility (LV) models
Based on one factor model with local volatility

= (rt − q )dt + σ (St , t )dBt

dSt
St
(Bt )t ≥0 : standard Brownian motion under risk - neutral measure
Sufficient degrees of freedom for perfect fit to volatility surface
advantage?
requires a complete volatility surface

6
 Examples of local volatility models
continuous theory
z Dupire
discrete (lattice-based) models
z Derman et al.
• binomial tree, trinomial tree model
drawback: Poor fit to volatility surface when volatility
changes significantly with strike or maturity

z Andersen and Brotherton-Ratclie

• semi-implicit and implicit scheme for PDE
• unconditionally stable

7
 consideration on existing LV models
Deeply dependent on the numerical method for solving FDM
The Computational cost of LV models is smaller than SV models.
Orthogonalization in the two-factor case is impossible by its
construction.
Consequently, the ADI method is not available.

method orthogonalization
ADI necessary
hopscotch necessary
line hopscotch not necessary
Strang symmetrization not necessary
8
Markov-functional (MF) interest rate model
one-factor interest rate model
perfect fit to term structure
can fit to some of swaption IVs

9
 swaption
Option to enter into Y-year interest rate swap
z at a specified date in the future (X)
z at a specified fixed rate (K)
We assume that IV for a swaption with
z X = Ti an example of swaption volatility

z Y = TN+1 - Ti
60%

σ ( i , N +1) 50%

(t ) 40%

30%

is available. 20%

10%

0%
K –independence 0

30
1

10
2
is postulated here.

5
X 4 Y

3
7

1 10
 notation
forward swap rates
( i , N +1) ⎧ Ti start date
Yt ⎨
⎩Ti +1 , Ti + 2 , L , TN +1 payment dates

present value of a basis point (PVBP) of a swap

N +1

∑ (T − T j −1 ) Dti ,T j
( i , N +1)
Pt = j
j =i +1 {
discount bond

valuation date : t
In this talk, we choose a numeraire pair
((D )
tTN +1 t ≥0
, F TN +1
) F TN +1 : forward measure.

11
 framework of MF interest rate model
A hidden process,
( X t )t ≥0 : standard Brownian motion under F TN +1 ,
explains everything:
DTi ,TN +1 = d ( i , N +1) X Ti , ( )
( )
N +1

∑ (T − T j −1 )DTi ,T j = p ( i , N +1) X Ti ,
( i , N +1)
PTi = j
j =i +1

YTi
( i , N +1)
( )
= y (i , N +1) X Ti
where
p ( i , N +1) : R → R + , d ( i , N +1) : R → R + and y ( i , N +1) : R → R +
is some monotone function which is not specified as of now.

12
 outline of MF interest rate model
“calibration”
1. construct a space-time lattice for X
2. determine the value of the numeraire at each node by backward induction

Once the numeraire at each node is obtained,

valuation of a claim on interest rate is straightforward since
•the governing SDE is very simple.
(No numerical difficulty in solving PDE)
•we can evaluate LIBORs, swap rates, forward LIBORs,
forward swap rates, and others on each node
by using the numeraire.

13
 backward induction
step 1 step 3
Suppose that the values of Determine
( i , N +1)
PTi+1
( i +1, N +1)
, YTi+1
( i +1, N +1)
and DTi+1 ,TN +1
yTi
on each node at Ti
are known on each node at Ti+1 . by using swaption IVs
and numeraire-rebased PVBP.

step 2 step 4
Evaluate numeraire-rebased PVBP at Ti Using the result of step 2 and 3, we can
( i , N +1) readily decide
PTi DTi ,TN +1
by simply applying the time propagation ( i , N +1)
operator to DTi ,TN +1 and PTi .
( i , N +1)
PTi+1 DTi+1 ,TN +1 .

14
 digital swaption (Step 3 in detail)
digital swaption with strike K and maturity Ti
z pays PVBP when swap rate is higher than K

( i , N +1)
payoff : 1y ( i , N +1 ) P
≥ K Ti
Ti

z We denote by V(i,N+1)(K, Ti ) the PV of this digital swaption at t.

15
 digital swaption PV in terms of swaption IVs
(Step 3 in detail)
PV formula of digital swaption under swaption measure:
⎡1 ( i ,N +1) PT (i , N +1) ⎤
V (K , t ) = E ⎢ yTi ≥ K i
( i , N +1)
y
( i , N +1) ⎥
= E ⎡1 y
( i , N +1) ⎤

Pt
( i , N +1) S ( i , N +1 )
⎢ PTi
( i , N +1) t
⎥ S ( i , N +1 )
⎢⎣ yTi ( i , N +1 )
≥K t
⎥⎦
⎣ ⎦

If swaption volatility is independent of K, it is identical to the IV of digital

swaption.
It follows expression of digital swaption PV in terms of swaption volatility:

⎡ yt (i , N +1) ⎤
V (i , N +1) (K , t ) ⎢ ln
K
−σ ( i , N +1) 2
(
(Ti − t ) / 2 ⎥ )
= Φ⎢ ⎥
Pt
( i , N +1)
⎢ σ ( i , N +1)
(Ti − t ) ⎥
⎢⎣ ⎥⎦

16
 PV of digital swaption from hidden process
(Step 3 in detail)
PV formula of digital swaption under forward measure:
⎡1 ( i ,N +1) PT ( i , N +1) ⎤
V (K , t ) = E ⎢ yTi ≥ K i
( i , N +1)
yt
( i , N +1) ⎥
F TN +1 ⎢ ⎥
Dt ,TN +1 DTi ,TN +1
⎣ ⎦

It follows
V (i , N +1) (K , t )
( i , N +1)
PTi
Dt ,TN +1
= ∑ 1 ( i ,N +1) −1 Ak ,i
x ≥( y
k∈{space index of nodes at Ti } i
) (K ) DTi ,TN +1
Ak ,i : arrival prob. to node (k , i )

If
(
z = y ( i , N +1) ) (K )
−1

is given, we can readily evaluate the RHS.

17
 two formulae for digital swaption (Step 3 in detail)
Now, we have two digital swaption PV formulae
z digital swaption value when strike is given in y-space coordinate
z digital swaption value when strike is given in X-space coordinate

K = y ( i , N +1) (x j ,i ) (x j ,i : value of X at node (j , i) )

By comparing these formulae,

we can determine the functional form of y(i,N+1).

18
 summary of MF interest rate model
A hidden process with a very simple SDE explains the
whole world: In the example above, we choose
z discount curve swaptions with X+Y=Ti-t.
z some of swaption volatilities
A backward induction is required.
We can use
z swaption volatility
as
z IV of digital swaption.

19
 numerical example
caplet-based MF model market IV

50%
45%
40%
MF value minus Market IV 35%
30%
25%
5% 20%
15%
4% 10%
5%
3%
0% 20
1 10
2% 7
3 5 Y
4
X 5 3
1% 10 1 2

0% swaption PV by MF model

-1%
50%
-2% 20 45%
1 10 40%
7
3 5 Y 35%
4
X 5 3 30%
10 1 2
25%
20%
15%
10%
5%
0% 20
1 10
7
3 5 Y
4
X 5 3
10 1 2

20
 MF skew model
A hidden process
( X t )t ≥0 : standard Brownian motion under risk - neutral measure Q
explains everything as before:
St = s( X t , t )
Here, monotone function
s : R2 → R+
is yet to be specified.

We consider equity options on

a single stock price, (St).

21
 outline of MF skew model
“calibration”
1. construct a time-space lattice for X
2. determine function s using IV for call / put options for each node

We use two formulae for digital call option with

payoff : 1ST ≥ K
i

Once stock price attached to each node is obtained,

any claim on stock price is evaluated straightforwardly.

22
 forward value of digital call in terms of IV
Partial derivative of BS formula for call option:
F ( K , Ti ) = Φ (D ( 0 ) (St / K , σ (K , Ti ), Ti − t ))
∂σ (K , Ti ) ( r − q )(T −t )
St Ti − tφ (D (1) (St / K , σ (K , Ti ), Ti − t ))
(1A)
− e i

∂K
where
∂
D (γ ) (κ , σ , t ) =
{
ln κ + r − q + (γ − 0.5)σ 2
} (ST − K )+ = −1ST ≥ K
∂K
σ t
and
dΦ ( x )
φ ( x) = : density function of normal dist.
dx

Note: When skew is present,

IV of digital call IV of call option
≠ ≡ σ ( K , Ti ) .
with strike K with strike K
23
forward value of digital call from hidden
process
Strike K corresponds to some z in X-space by
K = s ( z ) or z = s −1 ( K ),
Then, we have
⎛ −z ⎞
F ( K , Ti ) = Φ⎜ ⎟. (1B)
⎜ T −t ⎟
⎝ i ⎠

24
Now, we have two digital call forward value formulae
z digital call forward value when strike is given in S-space coordinate (1A)
z digital call forward value when strike is given in X-space coordinate (1B)
By comparing these formulae, (1A) and (1B), we can
determine s as in the case of the MF interest-rate model：
determine K = Kji
Use (1B) to evaluate which reproduces
digital call with z = xji the digital call value at z = xji
by (1A)

K ji = s (X ji )
25
 summary of MF skew model
A hidden process with a very simple SDE explains the
whole world:
z stock price
z entire volatility surface provided the surface is arbitrage-free
No backward induction is required for calibration.
z Stock prices attached to the nodes at each Ti (i=0,1,2,...) are determined
independently.
Note
z We can also construct MF skew model for interest rate, where backward
induction is necessary as in the MF interest rate model without skew.

26
 advantage of MF skew model
(among local volatility models)

numerical stability
z Stability depends on the FDM method. But, any FDM method is supposed to
handle standard Brownian motion properly.
z So, we can try advanced FDM methods which are
• faster than Crank-Nicholson,
• but is difficult to handle.

Fit to the volatility surface

easy to decorrelate in the two-factor cases

27
 an example of advanced FDM method
Smith’s optimal / near-optimal scheme
makes full use of five degrees of freedom within 3-point approximation:

Af n +1 = Bf n A, B : tridiagonal
j +1 j −1 j +1 j −1
Ai , j +1 f n +1 + Ai , j f n +1 + Ai , j −1 f n +1 = Bi , j +1 f n + Bi , j f n + Bi , j −1 f n
j j

1444444444444 424444444444444 3
5 degrees of freedom with coefficients of f n+1 and f n

28
 numerical example
100x100 lattice
200 days to maturity
50% 0.3%

45%

40%
0.2%
35%

30% MF skew (Smith)

MF skew (Crank-Nicholson)

error
25%
IV

0.1% market IV
error: MF skew (Smith)-market IV
20% error: MF skew (Crank-Nicholson)-market IV

15%
0.0%
10%

5%

0% -0.1%
60% 70% 80% 90% 100% 110% 120% 130% 140%
strike

29
 numerical example
100x100 lattice
200 days to maturity
50% 0.3%

45%

40% 0.2%

35%

30% 0.1% MF skew (Smith)

MF skew (Crank-Nicholson)

error
25%
IV

market IV
error: MF skew (Smith)-market IV
20% 0.0% error: MF skew (Crank-Nicholson)-market IV

15%

10% -0.1%

5%

0% -0.2%
60% 70% 80% 90% 100% 110% 120% 130% 140%
strike

30
 extension to two-factor model
When we introduce a second factor with
dYt = ν t dt + σ (t )dBt B : standard Brownian motion under the risk - neutral measure
d B, X t
= ρ (t )dt

the PDE to solve is

⎛ ∂ 1 ∂2 ∂2 σ 2 ∂2 ∂ ⎞
⎜⎜ + + ρσ + +ν − r ⎟⎟ f = 0,
⎝ ∂t 2 ∂x ∂x∂y 2 ∂y ∂y
2 2
⎠

which is easily orthogonalized.

31
 justifying local volatility models
two ways to determine delta
z Sticky-moneyness rule
assumes the parallel shift of volatility surface when stock price moves
z Sticky-implied tree rule
local volatility function (from stock price to local volatility) remains fixed
even if stock price changes.
Matytsin (2000) hedge ratio which minimizes
PL variance under the assumptions:

≈
delta by •SV model
stick-implied tree rule •portfolio is composed of stock and option
(incomplete market setting)

We have only one hedge tool (= stock) quite often.

32
 hedge simulation
Determine premium and delta
generate Paths
by MF skew model (LV)
by Heston
and Heston model (SV)

hedge simulation:
1. SV value + SV delta
Determine IV 2. SV value + LV delta
by Heston 3. LV value + SV delta
4. LV value + LV delta

33
 simulation setting
z Up and Out call (strike = 100 , barrier = 110, maturity = 6 months)
z daily rebalancing from date of issue to maturity: t = (0,3)
z S0 = 100
z Heston Parameters Initial volatility surface

Initial Vol = Long Term Vol = 30%

40%
Mean Reversion =4.0
35%
Vol of Variance = 80% 30%
Correlation = -0.5% 25%

20%

15%

10%
75%
5%
90%
Strike 105% 0%

3
2Y
1.5Y
1Y
9M
120%

6M
3M
2M
Maturity

34
 comparison of PL variances
500 trials
z A rough test for equality of variance is performed.
(F-test: Significance level : 5%)

strategy 0

SV value SV value LV value LV value

var. of strategy 1 + SV + LV + SV + LV
/ var. of strategy 0 delta delta delta delta

SV value
+ SV
delta 1.00 1.19 0.78 0.90 variance of strategy 0
< variance of strategy
SV value 1
+ LV
delta 0.84 1.00 0.66 0.75

LV value
+ SV
delta 1.28 1.53 1.00 1.15

LV value variance of strategy 0

+ LV > variance of strategy
strategy 1 delta 1.11 1.33 0.87 1.00 1

35
 summary
A simple, yet useful new local volatility model is
constructed which is motivated by the MF interest rate
model.
z Our model captures market volatility structure very accurately
and is stable irrespective of the numerical scheme for solving
PDEs.
z Orthogonalization in space direction and time propagation by
the ADI scheme is straightforward for a wide class of problems.

36
 References
E. Derman, I. Kani, and N. Chriss, Implied Trinomial Trees of the Volatility Smile,
Tech. rep., Goldman Sachs (1996).
L. Andersen and R. Brotherton-Ratcliffe, The equity option volatility smile: An implicit
finite difference approach, Journal of Computational Finance 1, 5–38 (1997).
P. Hunt, J. Kennedy, and A. Pelsser, Markov-Functional Interest Rate Models, Finance
and Stochastics 4, 391–408 (2000).
R. Smith, Optimal and near-optimal advection-diffusion finite-difference schemes. Part1:
constant coefficient 1-D, Phil. Trans. R. Soc. Lond. 455, 2371–2387 (1999).
A. Matytsin, Stochastic Volatility and Jump Diffusion In Equity Markets, Merril Lynch,
http://www.cirano.qc.ca/groupefinance/activites/fichiersfinance/matytsin.pdf ,
(2000).

R. Fengler, Arbitrage-free smoothing of the implied volatility surface, preprint (2005)

37