Pricing with a volatility smile

Guillaume Blacher, from Reech Capital PLC, is starting with this article a series of papers on volatility modeling for pricing and hedging exotics. Having carried on with Bruno Dupire some of the leading research projects on volatility smiles for quite a few years, I decided to retrace, with his consent, the different steps of our work in a series of papers on volatility. Little of it has been published by us and some of it has been published by others, generally quite some time after we implemented them and used them internally for daily pricing and risk management. In this first paper, I will expose what the smile model (also called local volatility model or for some obscure reason implied tree model) is and how it can be implemented practically, as a first step to answer some exotics pricing issues. Main theoretical results Black-Scholes was the first pricing model for options. It assumes the underlying follows a geometric brownian motion given by:

(t ) =

d ( 2 (T ) T ) dT
(T ) .

In other words, the local volatility function calibrated to the implied volatility

(t ) is

easily

2) Implicitly, the market uses different volatilities for different strikes. On equity markets, low strikes (out-of-the-money puts) would be priced with a higher volatility than high strikes (out-of-the-money calls). Question: can we extend the diffusion again to create this effect? Main break-through answer (Dupire 93): 1) Yes, we can design a diffusion that produces european prices that have different Black-Scholes implied volatilities for different strikes. Although there are several solutions (see further articles on jump diffusions, stochastic volatility and interpolation issues), the simplest extension we can probably think of is taking a local volatility that depends on the underlying spot price (typically having higher volatility when spot is low and lower volatility when spot is high):

dS t = dt + dWt St
being a constant drift (usually equal to interest rate minus repo minus dividend yield; actually, with no impact on european pricing, could be time dependent), being a constant volatility factor and W a standard brownian motion. This diffusion leads to a lognormal diffusion at any date in the future.
Under those assumptions, the price of any european option is given by analytical formula (the Black-Scholes formula). Unfortunately, those prices do not match with market prices of listed options, for several reasons: 1) Implicitly, the market uses different volatilities for different maturities. In other words, the implied volatility (the constant level of volatility that would need to go into a Black-Scholes to match the market price) is timedependent. This problem can be solved easily by a simple extension of the previous diffusion:

dS t = dt + (S , t )dWt St
2) If all market implied volatilities are given (i.e. we know the whole function (K , T ) ) and non-arbitrageable, (S , t ) exists and is unique. 3) We have an explicit formula for see Dupire[1]).

(S , t )

(For derivation,

dC dT 2 (K , T ) = 2 2 d C K dK 2 2
The existence of this means calibrating the model is not an issue anymore: the model is auto-calibrated as soon as this formula is used to compute the instantaneous volatility of our underlying. Two further derivations are necessary to produce an expression that can be used in production for exotics: a) A similar formula includes a couple of extra terms to account for the drift of the underlying, b) A second formula can be derived to get an explicit relationship between local volatility and implied volatilities directly (and not european prices, which although given by

dS t = dt + (t )dWt St
and is guaranteed to match market prices (or market implied volatilities (T ) for all maturities) as soon we have:

simple Black-Scholes formulae would make computations extremely slow). For derivation, see for example Andersen[1]. Practical implementation issues

to market prices. A minimisation algorithm will allow us to calibrate (S,t) to match the market.
33 28 23 18 50 100 Strike 150 50 100 Strike 150

32

Local volatility

Implied volatility

Several difficulties are faced when implementing a model with a local volatility given by Dupires formula. The first one is that we suppose all option prices (i.e. all implied volatilities) are available to us (any strike, any maturity). In the real world, only a few strikes and maturities will be quoted, forcing researcher to go through the painful process of interpolating implied volatility in maturity and strike. One cannot choose any interpolation method (like piecewise constant for example) as regularity constraints are imposed by the fact that we need to differentiate it to get to the local volatility. Also, smooth interpolation like spline functions can lead, because of small oscillations they create in some cases, to an arbitrageable implied volatility surface (even when initial inputs are not arbitrageable) which surely makes local volatility impossible to compute and makes the whole model blow-up. Despite all these and with possible sacrifices (like for example having a best fit rather than an exact fit of the input market implied volatility points), the model can be made to work very efficiently.
33 28 23 18 50 100 Strike 150

24 16

The method would be horrendously slow (a PDE for pricing each target call has to be solved) without the help of the forward PDE and handy bootstrapping in time. The forward PDE Let us reshape Dupires formula:

dC 1 2 d 2C (K , T )K 2 =0 dT 2 dK 2
This equation, when solved numerically, provides the price today, at current spot, of European option prices for all strikes and maturities. Using this trick will let us reprice all market calls and puts in one sweep of a PDE, dividing the overall calibration time by the number of instruments we are trying to match. Bootstrapping can also be implemented, allowing us to calibrate maturity after maturity, with no duplication of computation. The improvement is considerable and the method, although slower than when using Dupires formula, becomes tractable and honestly quite sexy. References Dupire[1]: B. Dupire Pricing and hedging with smiles. Proc AFFI Conf, La Baule June 1993 Andersen[1]: L.B.G. Andersen and R. Brotherton-Ratcliffe The equity option volatility smile: an implicit finite-difference approach, The Journal of Computational Finance, Winter 1997-98. Guillaume Blacher is a Senior Managing Director at Reech Capital PLC (reechcap@reech.com), a leading Capital Markets consulting group specialized in the Derivatives and Financing sectors. Guillaume Blacher is in charge of the Pricing Advisory and Risk Management division.

Implied volatility

32 24 16 50

Local volatility

100 Strike

150

Alternative implementation One of the possible criticism of the previous approach is nonintuitive shape of the local volatility surface obtained and its strong dependency in the interpolation method chosen. Although the impact when working out exotic option prices is not usually significant, our local volatility function might be difficult to justify and somewhat artificial. A different approach, more in line with classical blind calibration, would ignore Dupires formula and specify directly a functional form for the local volatility, which is made easier by the fact that there is no arbitrage constraint on local volatility. This way, we better control the assumptions of the model. For example, a simple piecewise bilinear function can be used for spot interpolation at each time period and for time interpolation. Plugging this local volatility function (S,t) into a numerical methods (Monte-Carlo, trinomial tree or most efficiently a PDE), European option prices can be calculated and compared