Aaihus School of Business, 0niveisity of Aaihus

Stochastic volatility Nouels with

applications to volatility Beiivatives

By Sibel 0cai & Liis Kivila
2009

Acknowledgements
Our gratitude and appreciation goes out to our supervisor Elisa Nicolato for her help, advise,
selflessness, and for being patience. We would also like to thank Thomas Kokholm for advising us
in times of need.






Abstract

The well-known Black and Scholes model from 1973 has several shortcomings, such as the
assumption of log normality of returns and constant volatility. Empirical research shows that the
volatility of returns is not constant and the implied volatilities of options show volatility skew or
smile. Taking this into consideration the benefits of using a non-constant volatility model becomes
apparent. On the basis of this, the option pricing framework in this thesis is the recognized Heston
model. In the Heston model, the underlying asset is allowed to be correlated with its volatility
process and has a mean reverting volatility process. This proves to be convenient when pricing plain
vanilla options. Nowadays, volatility derivatives are also available for trading and different models
are used to price them. Here, the Heston model`s pricing performance of VIX options is analysed and
the results show that the Heston model fails to price VIX options accurately.


Table of Contents
1.Introduction....................................................................................................................................................7
2.TheRationalofStochasticVolatilityModels...............................................................................................10
2.1Assumptions..........................................................................................................................................10
2.2RiskNeutralValuation...........................................................................................................................11
2.3BrownianMotion...................................................................................................................................11
2.4TheBlackScholesEquation...................................................................................................................12
2.4.1SolutionoftheBlackScholesEquation..........................................................................................14
2.5ThePutCallParity.................................................................................................................................16
2.5.1UpperandLowerBoundsforTheCallOptions..............................................................................17
2.6UsingFuturesPricesInsteadofInterestRate.......................................................................................18
2.7TheData.................................................................................................................................................19
2.8TheShortcomingsofBlackScholesModelinMarket...........................................................................21
2.8.1NormalityofReturns......................................................................................................................21
2.8.2TheVolatilityofReturnsandtheImpliedVolatilityoftheOptions..............................................23
3. StochasticVolatility.................................................................................................................................28
3.1TheHestonmodel.................................................................................................................................30
3.1.1CorrelationBetweenAssetPricesandItsStochasticVolatilityProcess.........................................31
3.1.2AdvantagesandDisadvantagesoftheHestonModel...................................................................31
3.2UseofMixingSolutionontheHestonmodel........................................................................................32
4. VolatilityandVarianceDerivatives..........................................................................................................35
4.2Applications...........................................................................................................................................35
4.3TheHistoryoftheVolatilityDerivatives................................................................................................36
4.4VarianceSwaps......................................................................................................................................37
4.5ReplicatingStrategy...............................................................................................................................38
4.5.1TheLogContract.............................................................................................................................41
4.6VolatilitySwaps,VolatilityandVarianceOptions..................................................................................43
4.7TheVIX...................................................................................................................................................45
4.7.1TheOldCBOEVolatilityIndex(VXO)..............................................................................................46
4.7.2TheNewVIX...................................................................................................................................47
4.7.2OtherVolatilityIndices...................................................................................................................49
4.8PricingOptionsontheVIX.....................................................................................................................50
5. PerformanceoftheHestonModel..........................................................................................................53
5.1MonteCarloSimulation.........................................................................................................................54
5.1.1MonteCarloSimulationforPlainVanillaOptions(SPXOptions)...................................................54
5.1.2MonteCarloSimulationforVolatility Option (VIX Options).......................................................55
5.1.3Convergence...................................................................................................................................56
5.2CalibrationScheme................................................................................................................................56
5.3TheComparisonoftheHestonModelPricesandtheMarketPrices...................................................58
5.4AveragePercentageErrorandAverageRelativePercentageError......................................................60
5.4.1TheAPEandARPEoftheSPXoptions............................................................................................61
5.4.2TheAPEandARPEoftheVIXoptions.............................................................................................63
5.5TheImpliedVolatilitySurfaceoftheHestonModelinComparisontotheImpliedVolatilitySurfaceof
theMarket...................................................................................................................................................64
5.5.1TheImpliedVolatilitySurfaceofSPXOptions...............................................................................64
5.5.2TheImpliedVolatilitySurfaceofVIXOptions...............................................................................67
6. TheEffectsofAlteringParametersintheHestonModel........................................................................73
6.1ParameterStability................................................................................................................................74
6.2TheEffectsofAlteringParametersintheHestonModelfortheSPXData.........................................76
6.2.1CurrentorInitialVolatility..............................................................................................................77
6.2.2LongrunVolatility..........................................................................................................................77
6.2.3MeanReversionSpeed...................................................................................................................79
6.2.4VolatilityofVolatility......................................................................................................................80
6.2.5TheCorrelationCoefficient............................................................................................................81
6.3TheEffectsofAlteringParametersintheHestonModelfortheVIXOptions......................................87
6.3.1CurrentorInitialVolatility..............................................................................................................88
6.3.2LongrunVolatility..........................................................................................................................89
6.3.3MeanReversionSpeed...................................................................................................................89
6.3.4VolatilityofVolatility......................................................................................................................90
7. Conclusion...............................................................................................................................................95
References.......................................................................................................................................................99
Appendix........................................................................................................................................................105
A.1..............................................................................................................................................................105
A.2..............................................................................................................................................................106
A.3.............................................................................................................................................................114
A.4..............................................................................................................................................................121

1. Introduction

Fischer Black and Myron Scholes first articulated the Black-Scholes (BS) formula in their 1973
paper, "The Pricing of Options and Corporate Liabilities". This was one of the early option pricing
formulas, where equity price follows a geometric Brownian motion with constant drift and
volatility. However, BS option pricing model has several imperfections while pricing options in the
market. Some of the shortcomings of BS are the assumptions of constant volatility and normality of the
returns. The observed market returns display non constant volatility, clustering and are not normal
distributed. This was noted at least as early as 1976 by Black (Black 1976). The implied volatility is
the volatility of the underlying which, when substituted into BS formula, gives a theoretical price
equal to the market price. The implied volatilities of options in the market show dependence on strike and
time to expiration and are not constant. If the BS model is correct, then all options on the same
underlying asset should give the same implied volatility. However, BS implied volatilities usually
vary across strike prices and across maturities. Taking limitations of BS into account, one might see the
apparent benefits of using non-constant volatility models


After the stock market crash in 1987, it was evident that volatility of the stock returns could not be
treated as a constant parameter. Hull and Whites model (1987) was one of the earliest and simplest
stochastic volatility models that was introduced in the same year the stock market crashed. Scott
(1989) considered the case in which the logarithm of the volatility is a mean reverting process and
this was further developed by Stein and Stein (1991). In 1993 Heston introduced a model where the
volatility is related to a mean reverting square root process. The mean reverting square root process
was first introduced by Cox, Ingersoll and Ross (1985) to imitate the behavior of risk-free interest
rate. Heston offers a stochastic volatility model that is not based on the BS formula. It provides a
closed form solution for the price of a European call option when the spot asset is correlated with
volatility (Heston 1993). These features made the Heston model popular for pricing plain vanilla
options. As popularity for volatility derivatives, such as volatility options, increased, investors
began to speculate whether stochastic volatility models for plain vanilla options could also be used
for pricing volatility options.
Volatility derivatives were introduced to provide investors an insurance against volatility risk.
Investors face two types of risk. The first type of risk is the price risk, which is the exposure to the
direction of the stock price. The second type of risk is the volatility risk that comes from the
exposure to changes in volatility. Previously investors would use a delta-hedged option position as a
means to hedge themselves. However, this does not provide a pure volatility hedge since the return
also depends on the underlying stock price. Yet, as imperfect as options are for volatility trading,
they were the only volatility vehicles available. However volatility derivatives have been launched
making it possible to trade volatility. A recent development has been the treatment of volatility as a
distinct asset which can be packaged in an index (volatility index). In 1993, the most popular
Chicago Board of Exchange (CBOE) Volatility Index was introduced also known as the VIX. The
VIX measures the implied volatility of S&P500 stock index options (SPX options) with maturity 30
days. In 2006 CBOE introduced options on VIX, enabling speculating and hedging volatility risk on
the S&P500 index. A range of option pricing models have appeared in order to price options on VIX.
The problem with using stock option pricing models to price VIX options is that the underlying VIX
characteristics differ from stocks and stock indices characteristics. For instance, one of the differences
between the VIX options and stock options is that VIX as an underlying is a mean-reverting process.
Therefore, an interesting question regarding VIX options is: how well do theoretical prices of a
stochastic volatility model, for example the Heston model, imitate market prices?

In this thesis, the main goal is to investigate the Heston model`s ability to capture the behavior of the
SPX options as well as VIX options. Since the Heston model is one of the most used stochastic
volatility models, only the performance of this model is analysed. The analyses of the model is judged
based on differences between the theoretical and market prices as well as implied volatilities. The BS
implied volatility is an alternative and more convenient way to express an option price when
comparing option prices across, for example, different strikes and maturities.

In order to price the options using the Heston model, Monte Carlo simulation is applied. Estimating
the parameters for the model requires calibration in order to fit the theoretical prices to market
prices. The calibration procedure is carried out for both SPX options and VIX options. An
additional goal, is to see whether the information gained from calibrated SPX options can be used to
price VIX options. As the parameters of the model have a great impact on the implied volatility
surface, further analyses is carried out to see how the altering of the obtained parameters affects the
implied volatility surface.

The content of this thesis is split into two main parts. The first part is mainly focusing on the
theoretical side of the content, which comprises chapters 2, 3 and 4. The second part, presented in
chapter 5 and 6, contains the results of implementing the theory.

In chapter 2, the framework for the BS is presented. Furthermore, the stylized features of returns are
shown and discrepancies between the BS model and market prices are examined. Chapter 3
introduces the background of the stochastic volatility models, particularly the Heston model.
Chapter 4 begins with introducing the history and applications of volatility derivatives, and further,
the use of variance swap is explained. Next, an explanation of replicating strategy is given by which
a variance swap can be replicated and valued. Hereafter, pricing of other derivatives based on
realised variance, such as volatility swaps, volatility and variance options, are explained. Lastly, the
CBOE volatility index VIX and the pricing of the VIX option is explained.

The second part starts by giving an overview of Monte Carlo simulation and calibration procedures,
respectively. The qualitative and the quantitative analysis of price differences between model and
market prices is performed. Chapter 5 finishes with the comparison of model and market implied
volatility surfaces. Chapter 6, investigates the effects of altering the parameters in the Heston model
on the implied volatility surface.

This overview of volatility derivatives, such as VIX options will give an understanding of what
volatility derivates are and how to use them. Furthermore, this thesis might trigger readers interest
in how to find and improve option pricing models that could be used to price the volatility options.

2. The Rational of Stochastic Volatility Models

Although the BS formula is often quite successful in explaining option prices (Black and Scholes
1973), it is well studied that the model contains several deficiencies (Rubinstein 1985). Results
using the BS model differ from real world prices due to simplifying assumptions of the model. One
significant limitation is that in reality security prices neither follow a strict stationary log-normal
process with constant volatility nor is the risk-free interest rate constant over time. The observed
returns display clustering and are not normal distributed. They are skewed and leptokurtic.
Furthermore, implied volatilities backed out from the option prices show dependence on strike and
time to expiration and are not constant. Pricing differences between empirical and the BS model
have long been observed for options that are far out-of-the-money (OTM), corresponding to
extreme price changes. Extreme price changes are more often observed in market then in a model,
which assumes log-normality of returns. Taking limitations of Black-Scholes into account, one
might see the apparent benefits of using non-constant volatility models. Nevertheless, Black
Scholes pricing is widely used in practice, for its easy to calculate and explicitly models the
relationship of all the variables. It is a useful approximation, particularly when analysing the
directionality of price movements.
2.1Assumptions

There are several assumptions involved in the derivation of the BS equation (Merton 1973). It is
important to understand these properly so as to understand the limitations of the theory. These
assumptions are summarized below:
1. The efficient market hypothesis is assumed to be satisfied. In other words, the markets are
assumed to be liquid, have price-continuity, be fair and provide all players with equal access
to available information. This implies that zero transaction costs are assumed in the Black-
Scholes analysis.
2. It is assumed that the underlying security is perfectly divisible and that short selling with full
use of proceeds is possible.
3. Constant risk-free interest rates are assumed. In other words, it is assumed that there exists a
risk-free security which returns $1 at time T when $1 c
-(1-t)
is invested at time t.
4. The Black-Scholes analysis requires continuous trading, meaning delta-hedging is done
continuously. This is, of course, not possible in practice as the more frequently one trades,
the larger the transaction costs.
5. The principle of no arbitrage is assumed to be satisfied.
6. In the Black-Scholes model, the price of the underlying security is assumed to follow a
geometric Brownian process of the form JS = pS Jt +oS Jw, where Jw
t
is a Wiener
process.
7. The model treats only European-style options.
2.2RiskNeutralValuation

This is one of the most important principle in derivative valuation. It states that the value of a
derivative is its expected future value discounted at the risk-free interest rate. This is exactly the
same result that would be obtained if it is assumed that the world was risk-neutral. In such a world,
investors would require no compensation for risk. This means that the expected return on all
securities would be the risk-free interest rate. This is a very useful principle as it states that it is
assumed that the world is risk-neutral when calculating option prices. The result would still be
correct in the real world even if (as it is the most probable case) it is not risk-neutral.
2.3BrownianMotion

Brownian motion (named after the Scottish botanist Robert Brown) first mentioned in 1828 is the seemingly
random movement of particles suspended in a fluid (i.e. a liquid or gas) or the mathematical model used to
describe such random movements. Brownian motion is among the simplest of the continuous-time stochastic
(or random) processes. Louis Bachelier used Brownian motion later in 1900 in his PhD thesis "The theory of
speculation", in which he presented a stochastic analysis of the stock and option markets. Brownian motion
can be also referred to as the Wiener process.
A variable W follows a Wiener process if it has the following two properties (Hull 2008):
1. The change W during a small period of time t is

Aw = eAt (2.1)
where follows a standardized normal distribution N(0,1) (i.e. normal distribution with a
mean of zero and standard deviation 1.0)
2. The values of W for any two different short intervals of time, t, are independent.
From the first property it can be seen that W itself follows a normal distribution N(0, t) with
standard deviation At. If a change in the value of W is considered during a relatively long period
of time, T, denoted by W(T)-W(0), then W(T)-W(0) is normally distributed N(0, T) and with a
standard deviation I. In the limit t0 , W=dW
2.4TheBlackScholesEquation
The model is named after Fischer Black and Myron Scholes (1973). Robert Merton (1973) also
participated in the models creation, and this is why the model is sometimes referred to as the
Black-Scholes-Merton model. Here is a derivation of the BS equation. From the ideal conditions in
the market mentioned above for an equity (and for an option on the equity), the authors show that
the value of an option (the BS formula) varies only with the stock price and time to expiry. Thus it
is possible to create a hedged position, consisting of a long position in one option and short the
amount delta, , in the underlying, whose value will not depend on the price of the stock. If this
portfolio is hedged continuously, the portfolio of the two is risk-free and the expected return is the
risk-free interest rate. In the following, the derivation of BS model will follow the procedure from
Wilmott (2007).
A general derivative V is considered, whose value is a function of the value of the underlying
security S. Another more conceptual assumption is that the price of the underlying S behaves like a
geometric Brownian motion. Geometric Brownian Motion (GBM) is a useful model by a practical
point of view. In other words, S is assumed to follow the stochastic process
dS
S
= pAt +oeAt (2.2)
The variable S is the change in the stock price S
t
, in a small time interval t .The variable has a
standard normal distribution. The parameter p is the expected rate of return per unit of time from
the stock and the parameter is the volatility of the stock price. In BS model these parameters are
assumed to be constants. The term t is the expected value of the return and the term oeAt is the
stochastic component of the return. The variance of the stochastic component and the whole return
is o
2
At. In the limit t0, the following stochastic differential equation is obtained
JS = pS Jt +oS Jw (2.3)
Using Ito's lemma (Hull 2008), it can be shown that
JI =
v
t
Jt +
v
S
JS +
1
2
o
2
S
2

2
v
S
2

Jt (2.4)
This cannot be valued directly as there is a stochastic term. To eliminate the stochastic term, the portfolio
L = I(S, t) -AS (2.5)
is considered. V(S,t) denotes a value of one long option position and is the amount short in the underlying.
The value of the hedged portfolio will change by
JL = JI(S, t) - AJS (2.6)
Using Ito`s lemma shows that the portfolio will change by
JL =
v
t
Jt +
v
S
JS +
1
2
o
2
S
2

2
v
S
2

Jt -AJS (2.7)
which can be rewritten
JL = [
v
t
+
1
2
o
2
S
2

2
v
S
2

Jt +[
v
S
- A JS (2.8)
The risk generating part on this equation comes from the term
[
v
S
- A JS (2.9)
The risk in the portfolio is removed if
[
v
S
- A = u (2.10)
Therefore, the quantity is chosen as
A =
v
S
(2.11)
In order to maintain the delta hedge, the amount must be changed whenever the right hand side of
the equation (2.11) changes. If the portfolio is delta hedged continuously (dynamic hedging
strategy), then a risk-less portfolio is constructed with a dynamics given by
JL = [
v
t
+
1
2
o
2
S
2

2
v
S
2

Jt (2.12)
Since there is no stochastic term, is a risk-free investment and hence must offer the same return as any
other risk-free investment. Therefore, from the no-arbitrage condition
JL = rLJt (2.13)
It is important to note that the portfolio represents a self-financing, replicating and hedging
strategy. It replicates a risk-free investment and it is hedged since it has no stochastic component.
Making substitutions to equation it is obtained that
[
v
t
+
1
2
o
2
S
2

2
v
S
2

Jt = r [I -S
v
S
Jt (2.14)

Simplifying the above equation, the BS equation is obtained.

[
v
t
+ rS
v
S
+
1
2
o
2
S
2

2
v
S
2

Jt = rI (2.15)

The final condition determines the kind of derivative that is priced. For a call option, the final condition used
is I = max (S - K, u). The principle of risk-neutral valuation is clearly satisfied in this case since the Black-
Scholes equation is independent of , the expected rate of growth of the underlying security price. When
taking into account the continuous dividend yield, q, the equation can be stated as

[
v
t
+ (r - q)S
v
S
+
1
2
o
2
S
2

2
v
S
2

Jt = rI (2.16)

2.4.1SolutionoftheBlackScholesEquation

There are several ways of solving the BS equation. Here, the one using the principle of risk-neutral
valuation is presented. This involves analyzing the assumed process for the stock prices
JS = pSJt +oSwJt using Ito's lemma and applying the principle of risk-neutral valuation to the result.
Applying Ito's lemma to JS = pSJt +oSJw gives
J(lnS) = [ -
c
2
2
Jt + oJw (2.17)
In fact, if S and S
0
are the prices of the underlying security at time T and t respectively, it can be easily seen
from the above equation that
lnS - lnS
0
~ Nj[ -
c
2
2
(I - t), oI - t [ (2.18)
and
lnS = NjlnS
0
+ [ -
c
2
2
(I - t), oI -t [ (2.19)
which shows that S follows a log-normal distribution. N(m,v) denotes a normal distribution with mean m and
variance v.
The principle of risk-neutral valuation implies that the present value of the call option C is the
expected final value E|max(S -K, u)] of the option discounted at the risk-free interest rate.
C = c
-(1-t)
E|mox(S -K, u) ] = c
-(1-t)
]
(S -K)g(S)JS

K
(2.20)
where g(S), the probability density function of S can be explicitly written as
g(S) = [
1
cS2n(1-t)
c
-
_ln_
S
S
0
]-_r-
o
2
2
_(T-t)_
2
2o
2
(T-t)
(2.21)

where has been replaced by r in accordance with the principle of risk-neutral valuation. It can be
verified that this solution satisfies the principle of risk-neutral valuation by evaluating.
E|S] = ] Sg(S)JS = S
0

0
c
(1-t)
(2.22)
The value of the integral (2.22) can be found with a bit of algebraic manipulation and is
C = S
0
N(J
1
) -K c
-(1-t)
N(J
2
) (2.23)
If the stock pays a continuous dividend rate q, then (2.23) becomes
C = c
-q(1-t)
S
0
N(J
1
) -K c
-(1-t)
N(J
2
) (2.24)
where
J
1
=
_In[
S
0
K
-_-q+
o
2
2
](1-t)_
c(1-t)
, J
2
=
_In[
S
0
K
-_-q-
o
2
2
](1-t)_
c(1-t)
= J
1
-o(I -t) (2.25)
and N(x) is the cumulative standard normal distribution.
And the equation (2.24) can be rearranged for the put

P = K c
-(1-t)
N(-J
2
) -c
-q(1-t)
S
0
N(-J
1
) (2.26)
While the result looks very complicated, it has an intuitive interpretation. Equation (2.24) can be
written as
C = c
-(1-t)
|c
-q(1-t)
S
0
N(J
1
) -K N(J
2
)] (2.27)
N(d
2
) is the probability that the final stock price will be above K (in other words, that the option will be
exercised) in a risk-neutral world. KN(d
2
) is the strike price times the probability that the strike price will be
paid. The expression S
0
N(J
1
)c
-q(1-t)
is the expected value of a variable S
1
if S
1
> K and zero
otherwise. In other words, c
-q(1-t)
S
0
N(J
1
) - K N(J
2
) is the expected value of the option at maturity. The
above result is therefore just an expression of the principle of risk-neutral valuation.

2.5ThePutCallParity

For a European put with same strike and maturity as for the European call, the put-call parity (Stoll
1969) can be used to find the value P. The relationship is derived using arbitrage arguments. Two
portfolios are considered:
Portfolio A: consists of a long position in a European put option plus c
-q(1-t)
amount of the
underlying with dividends being reinvested in additional shares.
Portfolio B: consists of a long position in a European call option plus cash being equal to an
amount of Kc
-(1-t)

Irrespective of the value of the underliying at expiration, each portfolio will have the same value as
the other, which is mox(S
1
, K) the two portfolios are going to have the same value at expiration,
then they must have the same value today.
The two portfolios can be expressed in the following way.
P + S
0
c
-q(1-t)
= C +K c
-(1-t)
(2.28)

2.5.1UpperandLowerBoundsforTheCallOptions

As most of the calculations in this thesis are done with call options, it is necessary to check whether
the prices of call options correspond to the no-arbritage requirement. It is known that the call price
has an upper and a lower bound (Hull 2008). If an option is above the upper bound or below the
lower bound, then there are profitable opportunities for arbritageurs.

It follows from equation (2.28) that in the absence of arbitrage opportunities the European call option has a
lower bound

C + K c
-(1-t)
S
0
c
-q(1-t)
(2.29)
Or
C S
0
c
-q(1-t)
-K c
-(1-t)
(2.30)


The upper bound for the call option is

C S
0
(2.31)

No matter what happens, the option can never be worth more than the stock. If this relationship was
not true, one could easily make a riskless profit by buying the stock and selling the call option.

2.6UsingFuturesPricesInsteadofInterestRate

In order to extract risk-free interest rates without any additional calibration the futures prices are
used. A futures contract written on the underlying (S&P 500 index or VIX) expiring at the same
date as the option written on the same underlying (S&P 500 index or VIX) is traded. Futures have
been chosen as it is more difficult to find a treasury-bill with exactly the same maturity as the
option.
In a futures contract, for no arbitrage to be possible, the forward price must be the same as the cost
(including interest) of buying and storing the asset. Thus, the futures price represents the expected
future value of the underlying discounted at the risk free rate. (Jarrow 1981) For a simple, non-
dividend paying asset, the value of the future/forward, F
0
, can be found by accumulating the present
value S
0
at time t to maturity T by the rate of risk-free return r.
F
0
= S
0
c
(1-t)
(2.32)
This relationship may be modified for dividends and then the following equation is obtained

F
0
= S
0
c
(-q)(1-t)
(2.33)
Futures and forward contracts are meant to deliver an asset on a future date at a prearranged price.
They are different in two main respects. Futures are exchange-traded, while forwards are traded
over-the-counter. Thus futures are standardized and face an exchange, while forwards are
customized and face a non-exchange counterparty. Futures are margined and settled daily, while
forwards are not. Thus futures have significantly less credit risk, and have different funding.
When the risk-free interest rate is constant and the same for all the maturities, the forward price for
a contract with a certain delivery date is in theory the same as the futures price for a contract with
that delivery date. (Hull 2008)


Equation (2.33) can be rearranged to find a discount factor c
-(1-t)
.

c
-(1-t)
= S
0
c
-q(T-t)
P
(2.34)

If the equation (2.34) is placed into the equations (2.24) and (2.25), then the equations for the
European call price C and the European put price P can be written as

C = c
-q(1-t)
S
0
N(J
1
) -K S
u
c
-q(I-t)
F
N(J
2
) (2.35)
P = K S
u
c
-q(I-t)
F
N(-J
2
) - c
-q(1-t)
S
0
N(-J
1
) (2.36)
In order to calculate a European call price C from the European put price, put-call parity is used (equation
(2.30))
C = P + c
-q(1-t)
S
0
- K c
-(1-t)
(2.37)

While using futures prices instead of interest rates, the following formula is obtained

C = P + c
-q(1-t)
S
0
- K S
u
c
-q(I-t)
F
(2.38)

Hence, the lower bound for the call price can be denoted as
C S
u
c
-qI
- K
S
u
c
-qI
F
= S
u
c
-qI
[1 -
K
F
(2.39)
which must be satisfied in order to avoid arbitrage opportunities.

2.7TheData

The data in this thesis consist of option data taken from Chicago Board Options Exchange (CBOE)
and futures prices taken from Chicago Mercantile Exchange (CME). The option market data is
based on two indexes. The first index used as an underlying is Standard & Poors 500 (S&P500) the
second one is VIX. S&P 500 is a value weighted index of 500 large-cap corporations traded on the
New York Stock Exchange (NYSE) and NASDAQ. VIX is the ticker symbol for the Chicago Board
Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day
volatility. The futures data is based on S&P500 index and VIX index.

The data of S&P500 options (SPX options), VIX options, futures on S&P 500 and VIX has been
directly downloaded from the websites of CBOE and CME (www.cboe.com, www.cme.com ). All
data have been collected while actively traded, starting from 24.04.09 and ending 14.07.09.

For the SPX call options and VIX options, the average bid-ask quote is calculated. For the put,
average bid-ask quotes are also calculated. In order to convert the average bid-ask quote of the put
to a converted call price, the put-call parity is used (equation (2.40)). To attain high liquidity in the
data and at the same time limit the total number of options, only options with a trading volume
higher than zero have been included. The original call price and the converted call price are
weighted with their corresponding volumes and weighted average is calculated, representing the
market price. Furthermore, market prices, which do not fall within the bid-ask range of original call
quotes are eliminated.

For the risk-free interest rate the futures prices are used, hence option prices without any matching
futures prices are disregarded. The equivalent futures prices are used in order to capture the risk-
free interest rate in the put-call parity (section 2.5). The time-to-maturities of the respective options
have been calculated on the basis of calendar days.

The dividend rate in calculations is based on Average Dividend Yield (%) of All S&P 500 stocks.
The "Estimated Dividend" for each stock is IndexArb`s best estimate of the per share amount that
will be paid during the next year, beginning on April-24-2009, which is 2.34%.
1
Most companies
pay dividends on a quarterly frequency; some pay annually or semi-annually. The amount, timing,
and growth of each dividend is forecasted from several years of dividend history, provided, of
course, that the company has an established track record. Otherwise, the most recent (perceived)
dividend policy is extended.

1
http://www.indexarb.com/dividendYieldSortedsp.html
2.8TheShortcomingsofBlackScholesModelinMarket

It is known that BS model does not capture the features of the stock market in reality. In the original
BS model, log-returns follow a normal distribution and the risk is quantified by a constant volatility
parameter. The research of market data show that log-returns are not normal distributed and do not
have a constant volatility. Formally, the volatility is the annualized standard deviation of the stocks
returns during the period of interest. The volatility that corresponds to actual market data for option
prices in BS model is called the implied volatility. This volatility is, in general, dependent on the
strike price forming a curve called volatility smile, but not flat as assumed by BS model. These
empirical facts will be investigated in the next section.

2.8.1NormalityofReturns

As mentioned earlier, the assumptions of BS model is that log-returns follow a normal distribution.
However, the observed returns in market do not satisfy this assumption. This can be proven by
looking at the returns series of S&P500 and investigating whether they follow the normal
distribution. The probability density function for a normal distribution (Gaussian distribution) is
given by the formula
p(x) = [
1
2nc
2
c
(x-)
2
2o
2
(2.41)
The probability density function has some notable properties including:
symmetry around its mean , therefore the skewness is zero
the mode and median both equal the mean
the inflection points (point where the curve changes sign) of the curve occur one standard
deviation away from the mean, i.e. at and + .
the kurtosis (describes the peakedness of a distribution) is equal to 3
The normal distribution is described by the mean and variance o
2
. In figure 2.1 the S&P500 log-
returns are shown and compared to the normal distribution. It can be seen that the log-returns of
S&P500 have fatter tails and higher peak than the normal distribution. The higher the peak of the
distribution and the more weight in the tails, the higher the kurtosis is. The calculated kurtosis for
S&P500 log-returns is 12.14. Fat tails and the high central peak are the characteristics of mixtures
of distributions with different variances (Gatheral 2005). This is a motivation to model variance as a
random variable. For the S&P500 index the considerable excess kurtosis is a strong indicator of
rejection of the null hypothesis. Furthermore the index is left skewed. The skewness is -0.1114. The
skewness may be an effect of traders reacting more strongly on negative information than on
positive (Rydberg 1997). The Jarque-Bera test rejects the normality of the returns (Table 2.1).
Figure 2.1. Panel (a): Normal and kernel estimated densities of S&P500 daily log-returns
2002-2009, panel (b): Log-normal and kernel estimated densities of S&P500 daily log-returns
2002-2009.


0
5
10
15
20
25
30
35
40
45
0,10 0,05 0,00 0,05 0,10
logreturns
(a)
S&P500returns Normaldensity
4
2
0
2
4
0,06 0,01 0,04
logreturns
(b)
S&P500lognormaldensity Lognormaldensity
Table 2.1: S&P500 index daily log-returns 2002-2009 statistics, using a statistics program
Eviews.

EVIEW
Mean 0,000122
Median 0,000577
Maximum 0,109572
Minimum 0,094695
Std.Dev. 0,014262
Skewness 0,111384
Kurtosis 12,13825
JarqueBera 6538,348
Probability 0
Observations 1878

2.8.2TheVolatilityofReturnsandtheImpliedVolatilityoftheOptions

The BS option pricing model takes the expiry, the strike, the underlying, the interest rate and the
volatility as an input to derive a theoretical value for an option. The volatility, , of a stock is a
measure of the uncertainty about the returns provided by the stock. A higher value for volatility
results in a higher theoretical value of the option. The implied volatility is the volatility of the
underlying which, when substituted into BS formula, gives a theoretical price equal to the market
price. Implied volatility is a forward-looking measure. In BS model, , is assumed to be known and
constant. BS model founded the modern theory of financial mathematics and is so widely used that
market practitioners quote prices for options in terms of their volatility rather than their actual price.
The BS implied volatility can be seen as a language in which to express an option price. In
analogical way a discount bond price can be quoted by giving its yield to maturity (YTM), which is
the interest rate such that the observed bond price is recovered by the usual constant interest rate
bond pricing formula. Therefore, as YTM is an alternative way of expressing a bond price, so is
implied volatility an alternative way of expressing an option price. The language of implied
volatility helps comparing option prices across different strikes, maturities, underlyings, and
observation times.

The value of an option depends on an estimate of the future realized volatility, , of the underlying.
The volatility is not however easily measured, because it describes the amount of fluctuation in
returns in the future. Therefore it has to be estimated. One way to estimate volatility is to calculate
historical volatility from known past prices of a security by taking the standard deviation of returns
provided by the stock in 1 year. (Hull 2008) Based on 21 trading days starting 21.05.09 and ending
18.06.09, the historical daily standard deviation of the returns on S&P 500 is 1.31 % . Assuming there
are 252 trading days per year, the historical volatility per annum is 20.87%. In figure 2.2 the 21-days
rolling window historical volatility of the S&P500 is plotted. The volatility is indeed not constant,
showing high fluctuations. Furthermore, when looking at the absolute returns, large changes tend to
be followed by large changes and small changes tend to be followed by small changes. This is
termed as volatility clustering. A quantitative manifestation of this fact is that, while returns
themselves are uncorrelated, absolute returns or their squares display a positive, significant and
slowly decaying autocorrelation function. In the model, this is a consequence of the mean reversion
of volatility. Comparison of figures 2.2 and 2.3 shows that S&P500 and its volatility level might be
negatively correlated. The correlation between VIX and SPX returns is -0.74 between 02.01.02-
18.06.09. The time-series of the S&P500 and VIX returns is taken from http://finance.yahoo.com.

If the assumptions of the BS model would hold in the market then the implied volatility of options
on a given spot with differing maturities and strikes would be the same. This is generally not the
case. (Tompkins 2001) Many different models have been suggested to fit the market data, or the
volatility smile, better. The volatility smile is a long-observed pattern in which at-the-money
options tend to have lower implied volatilities than in-the-money (ITM) or out-of-the-money
(OTM) options. Equity options traded in American markets did not show a volatility smile before
the crash of 1987 but began showing one afterwards. (Potter 2004) In reality, the implied volatility
of options has often been found to be decreasing and convex in the exercise price. In other words,
the implied volatility surface (IVS) when plotted versus moneyness tends to be skewed. An implied
volatility surface is a 3-D plot that combines volatility smile and term structure of volatility into a
consolidated view of all options for an underlier. When implied volatility is plotted against
moneyness (the ratio between the strike price and the underlying spot price), the graph describes
either an asymmetric smile or a smirk (Canina and Figlewski 1993; Rubinstein 1994). Campa and
Chang (1995) show that implied volatilities are a function of time to expiration. Furthermore, the
IVS is known to dynamically change over time, in response to news affecting investors beliefs and
portfolios. BS implied volatility is a highly non-linear function of option prices, therefore, a formal
treatment is difficult. The pattern displays different characteristics for different markets and results
from the probability of extreme moves. In figure 2.4 the implied volatilities of the options on the
S&P500 are displayed across moneyness and maturities. Here a smile or skew is clearly seen in the
Figure 2.2. Panel (a): Absolute log-returns of S&P500 2002-2009, panel (b): 21-day rolling
window volatility of S&P500 2002-2009



Figure 2.3. Time-series for S&P500 index 2002- 2009

0
0,02
0,04
0,06
0,08
0,1
0,12
a
b
s
(
l
o
g

r
e
t
u
r
n
s
)
20022009
(a)
0
0,2
0,4
0,6
0,8
1
v
o
l
a
t
i
l
i
t
y
20022009
(b)
500
700
900
1100
1300
1500
1700
S
&
P
5
0
0

i
n
d
e
x

v
a
l
u
e
20022009

Figure 2.4. Implied volatilities across maturities backed out from the SPX options market
prices.

0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
t=15days
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
t=30days
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
t=35days
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=55days
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=234days
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=325days
In conclusion, BS model is a quick and dirty way to obtain prices and widely used amongst
investors. However, it has several idealistic assumptions which are clearly not applicable to the
market. Some of them are the log-normality and the constant volatility of returns. The implied
volatilities backed out from stock options display a smile, yet, BS cannot replicate this behavior due
to its limitations. The content of the following chapters will digress from the BS world to a
stochastic volatility world.

3.Stochastic Volatility

After the stock market crash in 1987, it was evident that the volatility could not be treated as a
constant parameter. At that time investors felt the need for a model that could capture the variation
in the volatility process. One way of addressing the issue could have been letting volatility (t,s) be
a deterministic function of the random stock price making the volatility process a local volatility
model. However, local volatility models cannot explain the price of options, whose values depend
specifically on the randomness of volatility itself. Another natural idea was to make BS volatility a
random process, they are therefore, called stochastic volatility models.

The idea behind a stochastic volatility model is to incorporate the varying volatility and make the
volatility itself a stochastic process. Melino and Turnbull (1990) showed that the assumption of
stochastic volatility leads to a distribution of the underlying which is closer to empirical
observations than the log-normal distribution.

In a stochastic volatility model the volatility is changing randomly according to some stochastic
differential equation (SDE) or some discrete random process. When the underlying asset price S
follows a standard lognormal process at time t and volatility follows a stochastic process, then the
following SDEs are assumed to be satisfied
JS
t
=
t
S
t
Jt +
t
S
t
Jw
t
1
(S.1)
Jo
t
2
= o(S, o
2
, t)Jt +p[(S, o
2
, t)o
t
Jw
t
2
(S.2)
where the coefficients in the equations are
p
t
is the drift of stock price returns
o
t
2
is the variance for stock price returns
p is the volatility of volatility
the time variation of volatility involves an additional source of randomness, besides
w
t
1
, which is represented by w
t
2
. Hence, the Brownian motions are correlated
(Jw
t
1
Jw
t
2
) = pJt, where is the correlation.

By selecting different functions for o and [ in the equation (3.2) one can obtain different models.
Some of them are given in the following manner:

Hull and White (1987) Jo
t
= o
t
(oJt + yJZ
t
), p = u (3.3)
Scott (1987) Jo
t
= o
t
((o -[o
t
)Jt + yJw
t
) (3.4)
Stein and Stein (1991) Jo
t
= [(o -o
t
)Jt + yJw
t
, p = u (3.5)
Heston (1993) Jo
t
2
= (o
t
2
-o
2
)Jt +p
t
Jw
t
2
(3.6)

Hull and Whites (1987) model (equation 3.3) is one of the earliest and simplest stochastic volatility
models that was introduced in the same year the stock market crashed. The model describes the
stochastic evolution of variance by Brownian motion. In addition, the Hull and White model offers
a flexible distributional structure, this implies that the correlation between volatility shocks and
underlying assets returns contributes to the control of the level of skewness. By enabling the
management of volatility variation one can also control the level of kurtosis in the distribution.
(Yakoob 2002) Furthermore, Hull and White (1987) considered the case of = 0, and Wiggins
(1987) considered the general case of 0. In the Hull and White model the volatility is an
exponential Brownian motion, and it can grow indefinitely. Scott (1989) considered the case
(equation (3.4)) in which the logarithm of the volatility is a mean reverting process. Strictly positive
volatility is the main advantage of the models in equation (3.3) and (3.4). However, their
disadvantage is non-provision of a closed form solution. The model in equation (3.5) is an extended
version of equation (3.4) and introduced by Stein and Stein (1991). These authors examined the
case of being zero. In this model, the volatility process itself is a mean reverting process.
Nevertheless, the disadvantage of this model is that the volatility could go negative. The final
model (3.6) was introduced by Heston in 1993. The volatility is related to a square root process,
which was first introduced by Cox, Ingersoll and Ross (1985). The advantage of this model is that it
provides a closed form solution for European call options when the spot asset is correlated with the
volatility. In addition, this model is not based on the BS formula. For each small time step dt, this
model keeps the volatility positive and it is considered to be one of the most widely used stochastic
volatility model. (Schmitz 2004; Heston 1993) In this thesis, only the Heston model will be used.

3.1TheHestonmodel

The Heston model allows for correlation between the underlying asset and the volatility, and uses a
closed form solution for the price of a European call option. In this model the underlying asset price
S follows a standard log-normal process, and the underlying asset price at time t with dividend q
and risk-free interest rate r is assumed to follow the following process
JS
t
= (r -q)S
t
Jt +
t
S
t
Jw
1
(3.7)
Jo
t
2
= (o
t
2
-o
t
2
)Jt +po
t
Jw
2
(3.8)
The Heston model parameters are:

o
t
2
is the variance for stock price returns
the long-run variance o
t
2

the speed of mean reversion level
p is the volatility on volatility
the Brownian motions uw
t
1
and Jw
t
2
are correlated (Jw
t
1
Jw
t
2
) = pJt

As mention earlier, by selecting different functions for o(S, o
2
, t) and [(S, o
2
, t) in equation (3.2),
one can see how the Heston model can be acquired.
o(S, o
2
, t) = (o
2
-
t
2
) (3.9)
[(S, o
2
, t) = 1 (3.10)
The variance o
t
2
follows a mean-reverting square root process (used by Cox, Ingersoll and Ross
(1985)), the variance is always positive and will not reach zero if 2o
2
> p
2
, and the deterministic
part of process is asymptotically stable if > 0 (Mikhailov & Ngel 2003).




3.1.1CorrelationBetweenAssetPricesandItsStochasticVolatilityProcess

The Wiener process Jw
t
is defined as

w
t
= pw
t
2
+ (1 -p
2
)w
t
1
(3.11)
w
t
2
and w
t
1
are also Wiener processes (Romano & Touzi 1997). The processes w
t
2
and w
t
1
are
uncorrelated but w
t
and w
t
2
are correlated. The JS
t
is therefore expressed as
JS
t
= S
t
((r -q)Jt +o
t
|pw
t
2
+(1 -p
2
)
12
Jw
t
1
]) (3.12)
In other words, the correlation can also be seen as
(Jw
t
1
, w
t
2
) = p
t
(3.13)
So, the Heston process can be rewritten (Lewis 2002) as
JS
t
= (r -q)S
t
Jt +o
t
S
t
|pw
t
2
+(1 -p
2
)
12
Jw
t
1
] (3.14)
Jo
t
2
= (o
t
2
-o
t
2
)Jt +po
t
Jw
t
2
(3.15)

3.1.2AdvantagesandDisadvantagesoftheHestonModel

The Heston model has gain its popularity among practitioners. Its attractiveness lies in the powerful
duality of its tractability and robustness relative to other SV models, nevertheless, has its flaws.

Advantages of the Heston model
Closed form solution for the European options and thus the model allows a fast
calibration to given market data.
Unlike the BS model, the price dynamics in the Heston model allows for non log-
normal probability distributions.
The Heston model fits the implied volatility surface of the option prices in the
market.
The volatility is mean reverting.
The Heston model takes into account that equity returns and implied volatility are
negatively correlated, also known as the leverage effect (Black 1976). In addition, it
permits the correlation between the asset and the volatility to be changed.

Disadvantages of the Heston model
One of the main drawbacks of the Heston model (and other SV models in general) is
that since volatility is unobservable, the parameter values are not easily estimated.
The prices produced by the Heston model are quite parameter sensitive, hence the
fitness of the model depends on the calibration. In other words, the price to pay for
more realistic models is the increased complexity of model calibration. Often, the
estimation method for the parameters becomes as crucial as the model itself.
(Mikhailov & Ngel 2003)
The Heston model fails to produce decent results for short maturities as the model
fails to create a short term skew as strong as the one given by the market. To perform
well across large time interval of maturities further extensions of the model are
necessary. (Mikhailov & Ngel 2003)

3.2UseofMixingSolutionontheHestonmodel

This part examines the mixing solution related to this thesis. When calculating Heston models
prices, the mixing solution is applied because the theorem lets the stock prices and the volatility
process be correlated via their Brownian motions. The mixing solution is used in order to obtain
option values. The prices of the options are calculated by taking a weighted sum or a mixture of the
BS explicit solution values. The BS prices are calculated using different means and variances,
which follow a stochastic process.
The mixing solution was initially inspired by Romano and Touzis (1997) extended version of Hull
and Whites (1987) model, which did not allow for stock prices and volatility changes to be
correlated. Romano and Touzi modified Hull and Whites model by letting the stock price changes
and volatility changes to be correlated. However, their model only applied to put and call options,
but in Lewis (2002), the theorems were further extended to handle generalized payoff functions.

More specifically the mixing idea is based on the following steps:
Separate the stock price evolution into independent processes
Integrating out the variance and the mean
The integrated variables are inserted into the BS formula

The BS explicit solution is (equation 2.21)
S
1
= S
0
c
_(-q)-
1
2
c
2
]1+c1-N(0,1)
(3.16)
Moving to continuous time will allow for mixing solution to be incorporated. The explicit solution
for BS can then be rewritten in continuous time in the following manner
S
1
= S
0
c
[(-q)-
1
2
] c
t
2
dt
T
0
+ ]
t
dw
t
T
0
(3.17)
where w
t
is defined as a Brownian motion. To avoid confusion a new variable S
1
is introduced,
which only includes the stochastic part of the above equation, hence by dropping the constant part
of the equation, the initial stock price S
0
and the discounting factor c
(-q)
, the following equation is
obtained
S
1
1

= c
-
1
2
] c
t
2
dt
T
0
+] c
t
T
0
dw
t
(3.18)
This is the stock price for only one maturity. Note that in order to re-obtain the S
1
, one can just
multiply the S
1
1

with the initial stock price S

0
and the discounting factor c
(-q)
. As the eliminated
parts are equal to futures prices F
1
= S
0
c
(-q)1
, S
1
1

can be multiplied with the futures price. By

applying the rather convenient algebra of S

1
=
S
T
P
T
=
S
T
S
0
c
(r-q)T
, the interest rate estimation can be
avoided.
For the next maturity, S
1
2

is given by S
1
1

times the total variance, expressed in the following way

S
1
2

= S
1
1

c
-
1
2
] c
t
2
dt
T
2
T
1
+] c
t
T
2
T
1
dw
t
(3.19)
However, to make the above formula shorter, X = ] o
t
2
Jt
1
0
and = ] o
t
1
0
Jw
t
2
are introduced. By
inserting the X and Y into equation (3.18) the following is obtained
S
1
1

= c
-
1
2
X
T
1
+
T
1
(3.20)
And for the second maturity, again, S
1
1

is multiplied by the total variance for that maturity.

S
1
2

= S
1
1

c
-
1
2
(X
T
2
-X
T
1
)+(
T
2
-
T
1
)
(3.21)
The total variance for that maturity is obtained by taking the difference between the total variance
of the whole variance process up to I
2
and the total variance up to previous maturity I
1
. This
procedure will be carried out throughout all maturities. Hence, according to equation (3.14)
equation (3.21) can be rewritten by adding the correlation process, thus resulting in the following
equation
S
1
2

= S
1
1

c
-
1
2
(X
T
2
-X
T
1
)+p(
T
2
-
T
1
)
c
_(1-p
2
)
1
2
(X
T
2
-X
T
1
)dw
t
1
_
(3.22)
Next, the above result is multiplied with F
1
2
and the S
1
2
for that maturity is found.

In conclusion, stochastic volatility models are used to capture the volatility process of stock returns.
Various stochastic volatility models have been introduced, some more rigorous than the others. One
of the stochastic volatility models, the Heston model, has gained its popularity amongst
practitioners. It is important to remember that the Heston model is just a model, having its
disadvantages and advantages. It is a mathematical tool that models something that is noticeably
complex. All in all, stochastic models are powerful tools when the underlying assumptions are
thoroughly understood and carefully applied. To conclude this chapter, there are various ways to put
the Heston model in use and the mixing solution is one of them.
4.Volatility and Variance Derivatives

Price and volatility risk (vega risk) are the two main types of risks faced by an. Price risk is the
investors exposure to changes in the asset price. Volatility risk is the exposure to changes in
volatility. The volatility risk has been responsible for the collapse of major financial institutions in
the past 15 years (e.g., Barings Bank, Long Term Capital Management). Nowadays volatility
derivatives have been launched and therefore, volatility is a tradable market instrument. Previously
traders would use the exchange-traded standard futures and delta-hedged option positions as a
means to trade volatility. However, these instruments are designed to deal primarily with price risk.
Volatility derivatives are suitable candidates to hedge volatility.

Volatility derivatives are securities whose payoff depends on the realised variance or on future
realised variance of an underlying asset or an index return. Realised variance is the variance of the
underlying assets return over the life of the volatility derivative. The market for options on the
realized variance has been growing very rapidly in recent years. A recent development has been the
treatment of volatility as a distinct asset which can be packaged in an index (volatility index). As a
result, investors can trade in a variety of contracts starting from vanilla swaps on realised variance
up to options on the future realised variance. A variance swap has a payoff which is a linear
function of the realised variance, a volatility swap has a payoff which is a concave function of the
realized variance. (Sepp 2008 b; Broadie 2008; Psychoyios 2006)

4.2Applications

As mentioned earlier, volatility derivatives are used for various volatility trading. There are
different kind of traders: directional traders, spread traders and volatility hedgers. Directional
traders speculate on the future level of volatility, while spread traders bet on the difference between
realized and implied volatility. However, a volatility hedger uses volatility derivatives to cover
short volatility positions. For example, life insurance companies now offer many products with
guaranteed benefits (e.g., variable annuities or with-profits funds) and these expose them to short
volatility positions that may be offset by using variance swaps. Volatility derivatives are also used
in order to capture the spreads of volatility levels between two correlated indices. Hence the pricing
and hedging of these derivatives have become an important research problem in academia and
industry. (Petkovic 2008; Broadie 2008)

4.3TheHistoryoftheVolatilityDerivatives

After the crash of 1987 Brenner and Galai (1989, 1993) first suggested options written on a
volatility index that would serve as the underlying asset. Since then the theoretical background for
pricing options on the realized volatility has been developing. For example, Neuberger (1994)
showed that by delta hedging the log contract, which pays out the logarithm of the asset price at the
contract`s maturity time, the investor accrues the difference between the realized variance and the
implied variance. Whaley (1993) used the Black (1976) formula for options on futures contracts to
price options on an implied volatility index. In addition, Whaley (1993) constructed VIX (currently
termed VXO), a volatility index based on the S&P 100 options implied volatilities traded in the
Chicago Board of Exchange (CBOE). Since then, other implied volatility indices have also been
developed (e.g., VDAX in Germany, VXN in CBOE, VX1 and VX6 in France). CBOE introduced
a new methodology to calculate the implied volatility index in 2003. Grunbichler & Longstaff
(1996) adopted the Heston model to model the implied volatility index in continuous time setting
and price options on it. In an influential paper, Demeterfi et al (1999 a, b) examined properties of
variance and volatility swaps, where they show how to replicate the variance swap through a
dynamic trading strategy involving a portfolio of call and put options of all strikes with
appropriately chosen weights. This strategy allows a hedger to duplicate the pay-out of the variance
swap in a model independent fashion. Demeterfi et al (1999 a, b) also mentioned that for pricing
and hedging more complex options on the realized variance one needs to design an appropriate
model describing the stochastic dynamics of the market volatility surface. One of the candidate
models for this purpose is definitely the Heston stochastic volatility model (1993) which is
nowadays an industry-wide model. Various other ways to price volatility derivatives have been
investigated. Lipton (2000) priced volatility swaps using a PDE approach. Brockhaus and Long
(2000) discussed the pricing issues of volatility swaps based on Hestons stochastic volatility
model. Matytsin (2000) considered the valuation of volatility swaps and options on variance for a
stochastic volatility model with jump-diffusion dynamics. Little and Pant (2001) developed a finite
difference method for the valuation of variance swaps. Carr et al (2005) priced options on realised
variance by directly modeling the quadratic variation of underlying process. Broadie and Jain
(2007) showed that the convexity correction approximation does not provide a good estimate of fair
volatility strikes in the Heston stochastic volatility and the Merton jump-diffusion models. Among
others Elliott et al (2007) apply different stochastic volatility models for pricing and hedging of
variance and volatility swaps. (Sepp 2008 b; Broadie 2008; Psychoyios 2006)

4.4VarianceSwaps

In order to hedge against volatility risk a portfolio that responds to volatility or variance
independent of moves in the stock price has to be obtained. The easy way to trade volatility is to use
volatility or variance swaps. Variance swaps are forward contacts on future realized variance.
Similarly, there are volatility swaps, which are forward contracts on future realized volatility.
Volatility can be considered as a nonlinear function of variance and therefore volatility swaps are
more difficult to value and hedge. In addition to this, variance swaps can be perfectly replicated
with portfolio of vanilla options.

Since variance swaps are equivalent to forward contracts on the realized variance, pricing them is
not any different from other forward contracts. Hence, the contract has a payoff which is the
difference between realized variance and an agreed fixed leg K
u
.
F = (o
R
2
-K
u
)N (4.1)
where F is the forward contract, o
R
2
is the realized stock variance (quoted in annual terms) over the
life of the contract. The K
u
is the fair delivery value of the realized variance that gives the contract
a value of zero in present value:
K
u
= E(o
R
2
) (4.2)
The procedure for calculating realized volatility and variance is specified in the derivative contract.
Let t
0
=0 < t
1
< ... < t
N
= T be a partition of the time interval [0, T] into N equal segments of length
t, i.e., t
i
= iT/N for each i = 0, 1, ..., N. Most traded contracts define realized variance as

I
d(0,N,1)
=
AP
N
jln[
S
i+1
S
i
[
2
N
=1
(4.3)
for a derivative covering N return observations. Here S
i
is the price of the asset at the i
th

observationtime t
i
and the AF is the annualization factor. The contract includes also details about
the source and observation frequency of the price of the underlying asset and the annualization
factor to be used. In practice the annualization factor is typically AF=252. This definition of
realized variance in equation (4.3) differs from the usual definition of sample variance

I
d(0,N,1)
=
AP
N
jln[
S
i+1
S
i
[
2
-j
AP
N
ln [
S
i+1
S
i
[
2
N
=1
(4.4)
because the square of the sample average j
AP
N
ln[
S
i+1
S
i
[
2
is not subtracted. Since the sample average
is approximately zero, the realized variance is close to the sample variance. V
d
(0, N, T) is called the
discretely sampled realized variance and V
c
(0, T) the continuously sampled realized variance.
I
c
(u, I) = lim
n-
I
d
(u, N, I) (4.5)
In the stochastic volatility model, continuous realized variance is given by
I
c
(u, I) =
1
1
] o
t
2
Jt
1
0
(4.6)
In the Heston model (3.8) the expectation of variance is given by

E|I
c
(u, I)] = E j
1
1
] o
t
2
Jt
1
0
[ = E j
1-c
-kT
k1
(o
t
2
-o
2
) + o
2
[ (4.7)
where the last equation is explained in appendix A.1. (Gatheral 2005, Petkovic 2008). This method
is good for valuing the contract and it might seem fairly simple to obtain the future variance with
this method, but the problem still remains that no one knows the exact value of the future value with
certainty. Therefore, the correct way to value a swap is to value the portfolio that replicates it.

4.5ReplicatingStrategy

One way to capture realized variance is to replicate the variance by using a portfolio of vanilla
options. This is called the replicating strategy and the cost of implementing that strategy is the fair
value of future realized variance. The idea behind replicating strategy is to construct a portfolio of
options which is immune to stock price movements and gives the expected payoff of the future
realized variance at maturity T. The explanation of the replicating strategy below is based on
Demeterfi et al (1999 a, 1999 b).
An investor who takes a long position in the future realised variance should consider taking a
position in a portfolio instead of a single option. A single option would be an imperfect vehicle as
the investor would be not insured against further changes in variance if the stock price moves. By
taking a position in a portfolio, sensitivity to realized variance would be independent of the stock
price S. However, to obtain a portfolio independent of stock price movements an investor needs to
combine options of many strikes. Nevertheless, one problem remains, what combination of strikes
will give a pure variance exposure?
In order to ease the development of intuition, the riskless interest rate is assumed to be zero.
Suppose at time t an investor purchases a call option with the strike of K and expiration T, whose
value is given by the BS formula C
BS
(S, K, o, ) . From now on, W is denoted as the exposure of
an option to a stocks variance, in other words W is measuring the changes in value of the position
resulting from a change in variance. W is denoted as
w =
C
BS
c
2
=
S:
2c

cxp_-
d
1
2
2
_
2n
(4.8)
where
J
1
=
Iog[
S
K
+
o
2

2

c:
(4.9)
which is also known as the vega. Figure 4.1a demonstrates how W changes according to stock price
S. In the figure 4.1, three different options are presented with strikes 80, 100 and 120. It is clear
that, the W peaks when options are at-the-money and declines as the stock price moves ITM or
OTM. An option with higher strike will produce a W contribution that increases with stock price.
Figure 4.1b, d, f, and h, or the panels on the right hand side, illustrate the variance exposure for the
portfolio with their corresponding option strikes shown in Figure 4.1a, c, e, and g, the left hand
panel. The dotted line on the graphs from the right panel represents the sum of equally weighted
strikes; the solid line represents the sum with weights in inverse proportion to K
2
. Evidently, as the
options get more closely spaced the more insensitive the right hand side panel gets to stock price
movements, as long as stock prices lie inside the range of available strikes and far from the edge of
the range, and given the strikes are distributed evenly and closely.
Figure 4.1. The vega, W, of portfolios of call options of different strikes as a function of
stock price S. The panels on the left show individual contributions to the variance exposure for
each option with its corresponding strike. The figures on the right hand side show the sum of the
contributions to W respectively to the figure on the left. The dotted line represents the contributions
to variance exposure with an equally weighted sum of options. The solid line corresponds to
weights inversely proportional to K
2
, and W becomes totally independent of stock price S inside
the strike range. Source: Demeterfi et al (1999 a).

Investors trading the realized variance would need independency of the stock price movement, and
this can be obtained by creating a portfolio of options of all strikes, weighted in inverse proportion
to the K
2
level. Without going into the details of the mathematics behind W, the approach can be
understood intuitively. As an option with higher strike price and stock price is added in the
portfolio, an additional contribution to W proportional to that strike will also be added. An option
with higher strike will as a result produce a W contribution that increases with S. Furthermore, the
contributions of all options overlap at any definite S. Consequently, to offset this dependence to
stock price, one needs diminishing amounts of higher-strike options, with weights inversely
proportional to K
2
.

4.5.1TheLogContract

Now, it is known that in order to achieve sensitivity to realized variance, which is independent of
the stock price, vanilla options can be used. Below, it is explained how exactly those options should
be arranged in order to capture the realized variance according to Demeterfri et al (1999 a, 1999 b).
In this section it is assumed that underlying assets price moves continuously. Thus, it follows
dS
t
S
t
= p
t
Jt +o
t
JZ
t
(4.10)
Where the p and the o are assumed to be arbitrary functions of time and other parameters. The non-
dividend case has been chosen for the sake of simplicity.
By finding the Itos lemma of log S
t
the following equation is obtained
J(logS
t
) = [p -
1
2
o
2
Jt + oJZ
t
(4.11)
To isolate the variance and to remove the dependence of the the above equation will be subtracted
from
dS
t
S
t
, this gives
JS
t
S
t
-J(logS
t
) = _p -
1
2
o
2
] Jt + oJZ
t
- p
t
Jt +o
t
JZ
t

=
1
2
o
2
(4.12)
Taking the integral of this, leads to the continuous sample variance V from 0 to T, which is
expressed as follows
I
1
1
] o
2
1
0
Jt (4.13)
=
2
1
j]
dS
t
S
t
-
1
0
[log
S
T
S
0
[ (4.14)
This rearrangement describes the replicating procedure. It allows for capturing the variance
irrespective of the path the stock price takes, given that it moves continuously.
In a risk neutral world the underlying asset evolves differently from the one expressed in equation
(4.10). The drift with the will be replaced with the risk free interest rate.
dS
t
S
t
= r
t
Jt +o
t
JZ
t
(4.15)
By taking the expectation of the above equation, Brownian motion part drops out as taking the
expectation of the Brownian motion is zero. This leads to
E j]
dS
t
S
t
1
0
[ = rI (4.16)
Which means the K
u
can be rearranged to be
K
u
=
2
1
[rt -E jlog
S
T
S
0
[ (4.17)
From this rearrangement it is apparent that the log contract must be also replicated as there are no
actively traded log contracts. Hence, one duplicates the log payoff for all stock prices from time 0
up to maturity T using liquid options that is, using a combination of OTM call options for high
stock values and OTM put options for low stock values, as this proves to be convenient for practical
reasons. For this purpose a need of a new variable S
-
is needed that distinguishes put and call
options. In other words, S
-
is the at-the-money forward stock level marking the boundary between
liquid puts and liquid calls. The log payoff can be written as
log
S
T
S
0
= log
S
T
S
-
+log
S
-
S
0
(4.18)
The second term on the right hand side does not require any replication, as it is a constant and
independent of the final stock price. The first term is decomposed in the following way

-log
S
T
S
-
= -
S
T
- S
-
S
-
+]
1
K
2
S
-
0
Hox(K -S, u)JK +]
1
K
2

S
-
Hox(S -K, u)JK (4.19)
From a dealer's point of view, the variance swap is a replication of T-expiry log contract (which
decomposes of static positions in calls and puts on S), together with dynamic trading in S. Perfect
replication entails continuity of the price process, but does not require the dynamics of volatility to
be specified. Returning to the equation above, when the expectation of the first time on the right
hand side is taken, the following is attained
E j
S
T
- S
-
S
-
[ = [
S
0
c
rT
S
-
-1 = [
P
S
-
-1 (4.20)
Where the F is the forward price previously defined. By inserting the definitions into the K
u
one
more time and discounting the payoffs from the log contract, the final equation becomes
K
u
=
2
1
[rt -[
P
S
-
-1 -log
S
-
S
0
+c
1
]
1
K
2
S
-
0
P(K)JK +c
1
]
1
K
2

S
-
C(K)JK (4.21)
This formula is analogous to the VIX squared. In 2003, the variance swap's replicating portfolio
became the foundation for how the CBOE calculates the VIX index, an indicator of short-term
options implied volatility.


4.6VolatilitySwaps,VolatilityandVarianceOptions

Besides variance swaps there are also swaps written on volatility. For the volatility swap, the payoff
is
F = (o
R
-K
oI
)N (4.22)

where o
R
is the realized stock volatility (quoted in annual terms) over the life of the contract. The
K
oI
is the fair delivery value of the realized volatility. (Demeterfi et al 1999 a; Demeterfi et al
1999 b)
Hence, the fair volatility can be expressed as

E| I
c
(u, I) ] = E __
1
1
] o
t
2
Jt
1
0
_ (4.23)

The price of a variance call option is given by:
C
t
= E|c
-(1-t)
mox(I
c
(u, I) -K, u)] N (4.24)
Similarly the price of the variance put option is:

P
t
= E|c
-(1-t)
mox(K I
c
(u, I), u)] N 4.25)

where N is the notional amount in dollars. Unlike European equity options, the payoff of variance
options depends on realized variance I
c
(0, T) which is not a traded instrument in the market.

The fair volatility option price is defined as

C
t
= E|c
-(1-t)
mox(I
c
(u, I) -K , u)] N (4.26)
or
P
t
= E|c
-(1-t)
mox(K I
c
(u, I), u)] N (4.27)

4.6.1 Convexity

The payoff of a volatility swap is directly proportional to realized volatility. The payoff of a
variance swap is convex in volatility, as illustrated in Figure 4.2. This means that an investor who is
long a variance swap (i.e. receiving realized variance and paying strike at maturity) gains more than
a simple volatility swap when volatility increases and loses less than a volatility swap when
volatility decreases. This bias between volatility and variance is called convexity and because of the
spread the strike is slightly higher for a variance swap than the fair volatility, a phenomenon
which is amplified when volatility skew is steep. Jensens inequality shows how the expected
realized annualized volatility and the expected realized annualized variance are connected:

E| I
c
(u, I) ] E|I
c
(u, I)] (4.28)
Hence, the fair volatility strike is bounded above by the square root of the fair variance strike. Thus,
some authors have obtained an approximation of this convexity correction using Taylors
expansion, telling that the fair strike of a variance swap is often in line with the implied volatility of
the 90% put. However, Broadie and Jain (2007) show that it is not necessarily accurate in the SV
model.

Figure 4.2. Payoff of long variance and volatility swaps struck at 24 volatility points. Source:
Bossu 2005.


1.1.2 Variance swaps are convex in
4.7TheVIX

The Chicago Board of Options Exchange (CBOE) publishes indices of implied volatility. In 1993,
the most popular CBOE Volatility Index (VIX) was introduced. The VIX measures the implied
volatility of S&P500 stock index options with maturity 30 days. In other words, the VIX represents
the market's expectation of the annualized volatility of the S&P500 index over the next 30 day
period. The market often uses this implied volatility measure as a forecast of subsequent realized
volatility for stock market and also as an indicator of market stress (Whaley 2000). In general, VIX
starts to rise during times of financial turmoil and lessens as investors become complacent. The
negative correlation between the volatility and the stock market returns is well documented and
suggests including volatility in an investment portfolio. VIX futures and options are designed to
deliver pure volatility exposure in a single, efficient package. Trading in exchange-listed VIX
futures contracts started in 2004 and trading in VIX option contracts began in February 2006. One
contract is on 100 times the index. The VIX is computed by CBOE every minute using liquid
market quotes of short-term call and put options on the S&P500 index. In less than five years, the
combined trading activity in VIX options and futures has grown to more than 100,000 contracts per
day. (Sepp 2008 a, Sepp 2008 b; Carr 2006)

4.7.1TheOldCBOEVolatilityIndex(VXO)

Originally, VIX was designed to mimic the implied volatility of an at-the-money 1-month option on
the S&P100 index (OEX index). It was calculated by averaging the Black-Scholes implied
volatilities on eight near-the-money options (puts and calls) at the two nearest maturities. To
facilitate trading in the VIX, the definition of the index was changed on September 22, 2003. The
CBOE back-calculated the new index to 1990 based on historical option prices.

Figure 4.3. Panel (a): VIX 2002-2009, panel (b): VXO 2002-2009



Three important changes are being made to improve VIX. First, the new VIX measures a weighted
average of option prices across all strikes at two nearby maturities in order to incorporate
0
20
40
60
80
100
a
VIX
0
20
40
60
80
100
b
VXO
information from the volatility skew. The original VIX used only at-the-money options. Secondly,
the CBOE calculates the new volatility index VIX using market prices instead of implied
volatilities. Therefore, a newly developed formula is used. Thirdly, the new definition uses the S&P
500 index (SPX) to replace the OEX as the underlying stock index. The CBOE renamed the old
VIX the VXO, and it continues to provide quotes on this index. One can see from the figure 4.3 that
VIX and VXO do not differ much. (Gatheral 2006)

4.7.2TheNewVIX

Stock indexes, such as the S&P 500, are calculated based on its component stock prices. Each index
has its own rules of selecting securities and a specific formula in order to calculate the index value.
VIX value is based on the prices of options rather than stocks. The price of each option reflects the
markets expectation of future volatility. Like conventional indexes, VIX employs rules for
selecting component options and a formula to calculate index values.

The general formula for the new VIX calculation at time t is

o
2
=
2
1-t

AK
i
K
2
c
(1-t)

t
(K

, I )

-
1
1-t
j
P
t
K
0
-1[
2
(4.29)

Where

is VIX/100 VIX= *100
T is the time to expiration for all of the options involved in this calculation
F
t
is the forward S&P 500 index price derived from index option prices
K
i
is the strike price of the i-th OTM option in the calculation
Q
t
(K
i
,T ) is the midpoint of the bid-ask spread for each option with strike K

K
0
is the first strike below the forward index level F
t

r

is the risk-free interest rate to expiration
AK

denotes the interval between strike prices half the difference between the
strike on either side of K

defined as:

AK

=
K
i+1
- K
i+1
2
(4.30)

Equation (4.29) uses only OTM SPX calls and OTM SPX puts centered around an at-the-money
strike price, K
0
. Two options are selected at K0, while a single option, either a put or a call, is used
for every other strike price. The K0 put and call prices are averaged to produce a single value. The
CBOE chooses K
0
by identifying the strike price at which the absolute difference between the call
and put prices is smallest. The forward price is derived via the put-call parity relation:
F
t
= K
0
+ c
(1-t)
(C(K
u
, I ) - P(K
u
, I )) (4.31)

Since K
0
F
t
, one unit of in-the-money call is used at K
0
. The last term in Equation (4.29) represents
the adjustment needed to convert this in-the-money call into an out-of-the-money put using put call
parity.

If the SPX option quoted has a zero bid price then this price is disregarded. Therefore, as volatility
rises and falls, the strike price range of options with nonzero bids tends to expand and contract.
Consequently, the number of options used in the VIX calculation may vary from month-to-month,
day-to-day and possibly, even minute-to-minute.

Equation (4.28) is used to calculate
2
at two of the nearest maturities of the available options, I
1

and I
2
. Then, the CBOE interpolates between o
1
2
and o
2
2
and annualizes the result using an
actual/365 day-counting convention to obtain a VIX. The actual/365 day-counting convention
avoids the artificial upward bias incurred in the VXO calculation. The formula for this is

IIX = 1uu_
365
30
j(I
1
-t)o
1
2
[
NC
1
-30
NC
2
-NC
1
+ (I
2
-t)o
2
2
[
30-NC
2
NC
2
-NC
1
[ (4.32)

where NC
1
and NC
2
denote the number of actual days to expiration for the two maturities. The
nearest time to maturity must have at least 8 days to expiration. This is needed in order to avoid
pricing anomalies that might occur close to expiration. When the near-term options have less than 8
days to expiration the CBOE switches to the next-nearest maturity. (Carr 2006)

Equity traders are used to stock options and index options expiring on or just before the third Friday
of the month. VIX options are different and have a very unusual expiration date. VIX options expire
on the Wednesday that is at least 30 days before the 3rd Friday of the month following the
expiration month.

VIX is an indicator of the "investor fear gauge" because it reflects investor's best prediction of near-
term market volatility, or risk. If implied volatility is high, the premium on options will be high and
vice versa. The increase in option premiums (assuming all other variables remain constant) is
reflected in rising expectation of future volatility of the underlying stock index, which represents
higher implied volatility levels. Each time the VIX has declined below 20, a major sell-off has taken
place shortly after. Whenever the VIX drops below 20, the stock market marks a medium-term top.
In the current financial crisis the VIX peaked at 80% in November 2008.
2


4.7.2OtherVolatilityIndices

In addition to VIX, CBOE calculates volatility indexes on three other indexes representing different
segments of the U.S. stock market:
CBOE DJIA Volatility Index (VXD) based on options on the Dow Jones Industrial
Average (DJX);
CBOE Nasdaq-100 Volatility Index (VXN) based on Nasdaq-100 Index (NDX)
options; and
CBOE Russell 2000 Volatility Index (RVX) based on Russell 2000 Index (RUT)
options.

There is another Index written on S&P 500, which is a CBOE S&P 500 3-Month Volatility Index
(VXV). Comparing VIX and VXV provides investors with information about the SPX volatility
term structure in the next four months. Currently, VXV, VXD and RVX futures are listed on CFE
and options on RVX are traded on CBOE.

2
ht t p: / / www. invest opedia. com/ art icles/ opt ioninvest or/ 03/ 091003. asp?viewed= 1
In 2008 CBOE started to calculate two commodity volatility indexes and one currency volatility
index:
CBOE Crude Oil Volatility Index (OVX) based on United States Oil Fund, LP
(USO) options;
CBOE Gold Volatility Index (GVZ) based on the, SPDR Gold Shares (GLD)
options; and
CBOE EuroCurrency Volatility Index (EVZ) based on Currency Shares Euro Trust
(FXE) options

For each of the volatility indexes, the method of selecting component options and the formula are
the same to that used for VIX.(Exchange C.B.O. 2004)

4.8PricingOptionsontheVIX

A VIX option is a type of non-equity option that uses the CBOE Volatility Index as the underlying
asset. This is the first exchange-traded option that gives investors the ability to trade market
volatility. Trading VIX options can be used to hedge portfolios against sudden market declines, as
well as to speculate on future moves in volatility. A trader who believes that market volatility will
increase has the ability to profit on this outlook by purchasing VIX call options. VIX futures may
also provide an effective way to hedge equity returns, to diversify portfolios, and to spread implied
against realized volatility. The spot value of VIX at time T measures the square root of the expected
annualized variance for SPX options with tenor
T
=30/365 in the Heston model. The VIX is
modeled by assuming that the variance of returns on the S&P500 index is driven by dynamics
(equation 3.8). The spot value of the VIX at time T can be written as

E|IIX] = E|I
c
(I, I +
T
) J(I)](4.33)

where filtration J(I) contains all information available at time T and where

E| I
c
(I, I +
1
) ] = E __
1
:
T
] o
1
2
Jt
1+:
T
1
_ = _
1-c
-k
T
k:
T
(o
1
2
-o
2
) +o
2
(4.34)

The futures value of the VIX is today`s expectation of the VIX at time T

E|IIX] = E| E{I
c
(I, I +Su uays) J(I)]J(t)] N (4.35)

The VIX futures market and SPX options market provides the information basis for launching VIX
options. A call option on VIX is considered to have a terminal payoff of (IIX
1
-K)
+
. According
to the market convention, the VIX, the VIX futures and VIX options are scaled by the factor of 100,
meaning N=100. The value of the option written on VIX, C
t
, is dependent on todays expectation of
the VIX at time T. T is the expiration date for the option written on VIX. Inserting the equation
(4.35) into the equation (4.26) gives

C
t
= E|c
-(1-t)
mox(E{I
c
(I, I +Su uays) J(I)] -K, u) J(t)] N(4.36)

Using equation (2.34 ) for using futures price as a discount rate, equation above becomes

C
t
= E j
vIX
t
P
mox(E{I
c
(I, I +Su uays) J(I)] -K, u) J(t)[ N(4.37)

It has been shown that the probability density function of the VIX spot value corresponds to the
shifted processes of the original volatility. In other words, VIX has a limited down-side potential
while the likelihood of up-side values is equivalent to the original volatility processes. Accordingly,
a short position in the VIX futures and options contracts is associated with rather limited gains and
virtually unlimited losses. (Sepp 2008 b)

One important thing to know about VIX options is that they are European options. If the options
have a couple of weeks until expiration, this has the practical effect of causing option prices to be
relatively insensitive to large jumps on the VIX index, contrary to what would be expected if these
were American options. This is because there is a high probability that after two weeks, the index
will have relaxed and the options will be out OTM. With this in mind, buying VIX options anytime
until about a week before expiration seems more risky than necessary.
3


In conclusion, volatility derivatives are instruments whose payoff depends on the realised variance
of an underlying stock or an index return. Recently, volatility has been packaged in an index
making it easier to trade volatility and insure a trader against the volatility risk. The most well-
known volatility index is the VIX and since 2006 options on VIX are available. Pricing those
options needs an estimation of future realized variance, which is not a trivial task. One of the
methods could be to use the Heston model to capture the VIX process.

3
http://seekingalpha.com/article/68240-investigating-the-vix-s-p-500-correlation
5.Performance of the Heston Model

This chapter shows how well the Heston model is able to capture the behavior of the options in the
market. It is known that the Heston model is somewhat able to imitate the behavior of the plain
vanilla options and definitely behaves better than BS model (Florentini 2002). However, the Heston
model`s ability to imitate the prices of volatility options has been shown to be not so successful
(Wang 2009). In this thesis, these plain vanilla and volatility options are priced using the Heston
model and their fit to the market data is discussed. The options priced in this thesis are:
SPX options data representing plain vanilla options.
VIX options data representing volatility options.
Another question is, whether the information from the SPX market is useful in pricing the VIX
options. In other words, it is shown whether the parameters obtained from SPX options calibration
can be used in order to price the VIX options on the same day.
SPX options market prices, prices calculated using BS and prices calculated by calibrated Heston
model are compared to measure the performance of the Heston Model for the SPX options.
To estimate the behavior of the Heston model`s ability to capture the VIX options prices, VIX
option market prices are compared with the VIX option prices obtained by the Heston model. VIX
option prices are calculated with the Heston model using two different sets of parameters:
1. obtained from calibrating VIX option prices with VIX option algorithm (VIXVIX Heston).
2. obtained from already calibrated SPX options with SPX options algorithm (VIXSPX
Heston). The date of the SPX options data corresponds to the date of the VIX options data.
The fitness of the model is judged comparing the option prices as well as implied volatilities.



5.1MonteCarloSimulation

Simulation is a method in which random numbers are generated according to probabilities assumed
to be connected with a source of uncertainty, such as interest rates, exchange rates or commodity
prices more appropriately for this thesis, stock prices and option prices. Outcomes associated with
these random drawings are then analyzed to determine the possible results and the associated risks.
Often this method is called Monte Carlo simulation, being named for the city of Monte Carlo,
which is famous for its casinos.
In addition, Monte Carlo simulation is a widely used technique for dealing with uncertainty in many
aspects of business operations. It has been shown to be an accurate method of pricing options and
particularly useful for path-dependent options and others for which no known formula exists.
Monte Carlo simulation has been used to value European options since Boyles paper of 1977. The
method simulates the process generating the returns on the underlying asset and invokes the risk
neutrality assumption to derive the value of the option. The general procedure for Monte Carlo
simulation to evaluate (S, u) = c
-t
E|(S
1
, I)] is
Produce a large number N of outcomes S
0<t<1

, {i = 1, N] of the risk neutral underlying.

Approximate E|(S
1
, I)] and then calculate the arithmetic average at maturity of the
corresponding payoff, i.e.

E|(S
1
, I)] =
1
N
(S
1

, I)
N
=1
(5.1)

Discount according to the risk-free interest rate r, or more relevant to this thesis, according
to the futures prices

5.1.1MonteCarloSimulationforPlainVanillaOptions(SPXOptions)

The procedure to simulate the Heston option prices for a European call option is as follows.
For part one, it is necessary to simulate a stock price path and a variance path over the life of the
option. First, a discretization of time into G pieces is done, where each time step is given by
At = I0. In this case the time-step is chosen to be one day At =1/365. By using Euler
discretization o
2
t+At
is generated using equation (3.8). Next, S
t+At
is generated using equation
(3.22). In both of these cases, everything on the right hand side of the equation is known except for
Jw
t
1
and Jw
t
2
. Using these simple transformations, S
t+At
and o
2
t+At
are easily simulated. To
complete part one, the simulation is repeated G times, until a single complete path is generated for
both the stock and the variance.
Part two is to calculate the payoff of the European call option at the last simulated stock
price, max(S
1
-K, u), which will be at expiration date T. This payoff is later discounted using
futures and recorded. Another number to be determined is the number of simulations N, which
shows how many times part one and part two is repeated. For accurate results the number of
simulations should be relatively high. The recorded outcomes are then averaged to get an estimate
for the call price.

5.1.2MonteCarloSimulationforVolatility Option (VIX Options)

The simulation procedure of the Heston option prices for a volatility option (VIX option) differs a
little from the simulation of plain vanilla options.
For part one, it is still necessary to simulate a stock price path and a variance path over the life of
the option. In the volatility option case the variance path is basically the stock price path. The time
step is chosen to be again one day, At =1/365 and the path for the process is divided into G=T/ At
pieces. For the VIX option the simulation of the variance path is divided into two parts. First,
o
2
t+At
is generated using the Euler discretization and the equation (3.8). Now only Jw
t
1
is not
known. The simulation is repeated G times. Second, since the VIX option is an option on future
realized volatility, at time T the expectation of the variance process in next 30 days (VIX index
value) has to be estimated. The expected value for VIX is obtained, using the final outcome of the
o
2
t+At
process as the initial volatility o
t
2
in the equation (4.7) and taking the square root of the
result.
Similar procedure is carried out for the 2nd part.
5.1.3Convergence

As mentioned earlier, Monte Carlo simulation has been known to produce accurate results. This
concept has been tested by comparing Monte Carlo option price with the theoretical option price
given by Black-Scholes model. Naturally every simulation is different as each set of random
numbers is different. A Monte Carlo procedure written in Excels Visual Basic produces the
following values for the call, whose actual Black-Scholes price is 579.50. The number of random
drawings is the sample size, N.

Table 5.1. The call prices obtained according to the number of simulations
N 1,000 10,000 50,000 100,000
Call price 558,6 551,2 583.8 575,6

The option price obtained from a Monte Carlo simulation is a sample average. As expected, the
Monte Carlo converges to the true value as the number of simulations increases, meaning that the
standard deviation of the estimate decreases. Given that an option has a closed form solution, one
can compare its outcomes to the Monte Carlo approximation in order to test the reliability of the
result. In the current thesis 100000 simulations are run.

5.2CalibrationScheme

In order to calculate option prices using the Heston model and Monte Carlo simulation method, the
parameters in the Heston model should be estimated. In the current thesis, each day the SPX options
data is downloaded it is also calibrated. There are five parameters that need estimation in the Heston
model: , o
2
,

o
t
2
, p, p . Later on, on the same day as SPX options data is downloaded, also VIX
options data is downloaded and calibrated separately from SPX options data. Both, the SPX options
data calibration and the calibration of the VIX options data is carried out for the options across all
maturities at the same time. As the Heston model used for pricing the VIX options does not have a
correlation coefficient , only four remaining parameters are calibrated for the VIX options data.
The parameters obtained from the calibration procedure resemble the current market view on the
asset. Any historical data will not be explicitly taken into account. All the necessary information is
combined in todays option prices, which is observed in the market. (Schoutens 2003)
As highlighted in previous sections, when pricing with stochastic volatility models the correctness
of the parameters depends very much on the estimation method of the parameters, in other words on
the calibration. For this reason, it is very important to choose a correct method for the calibration.
Research has shown that the implied parameters (i.e. those parameters that produce the correct
option prices) and their time-series estimate counterparts are different. So one cannot just use
empirical estimates for the parameters. This leads to a complication that plagues stochastic volatility
models in general. (Moodley 2005)
One way to evaluate parameters of the model is to find those parameters which produce market
prices of the derivative, also known as the inverse problem. The inverse problem can be solved by
minimizing the error or difference between model prices and market prices, also known as the non-
linear least-squares optimization problem. For this thesis the least squared error fit have been
chosen. For SPX options data, the purpose is to minimize the square differences between the
S&P500 call option and the Heston call prices. For VIX options data, the purpose is to minimize the
square differences between the VIX call option and the Heston call prices. Results are discussed in
Appendix A.4.
min(0) SqErr(0) = min (0) (C

U
-C

M
)
2
N
=1
, (i = 1N) (5.2)
where C
U
and C
M
are call prices from the model and the market, respectively, the 0 is a set of
parameters in the Heston model, and the N is the number of derivatives used for calibration. For the
calibration the parameters have been constrained to be 2o
t
2
-p
2
> u in order to avoid reaching
zero in the volatility process, also known as the Feller constraint (Cox, Ingersoll & Ross 1985). In
addition, the parameters are conditioned to be as follows:
the long-run volatility is constrained to u < o
t
< 2
the speed of mean reversion level is constrained to u <
the volatility for stock prices returns is constrained to u < o
the volatility on volatility is constrained to u < p
The correlation is constrained to -1 < p < 1

The calibration is done in the standard Microsoft Excel by using its built-in solver function. It uses a
Generalized Reduced Gradient (GRG) method and hence is a local optimizer. The calibration
results are therefore extremely sensitive to the initial estimates of the parameters. This optimizer
should only be used when one is sure that the initial estimates are quite close to the optimal
parameter set. In addition, Excel is ineffective at tackling calculations with very small numbers. The
minimization problem given with the equation is relatively easy to implement, nevertheless it tends
to arise few problems as the function SqErr(0) is usually not convex and does not have any
particular structure. An additional problem is that there might not exist a unique solution meaning
that once the local minimum is found one cannot be sure that it is the correct solution. (Mikhailov &
Ngel 2003)
Having calibrated one parameter, another parameter is picked and calibrated on its own, by keeping
the first parameter fixed. Once both parameters are calibrated, a joint calibration is carried out,
giving the initial guesses the parameter values had obtained from single calibrations. Next, another
parameter is picked and calibrated before calibrating jointly. This procedure is carried out till the
last parameter is included in the joint calibration. This procedure is not particularly rigorous as it
requires trial and error, and in theory all parameters should be calibrated at one time. As Excel
solver has its flaws in calibrating over all parameters at once, therefore, one by one calibration of
parametes is carried out. For the next dataset, previous dataset`s corresponding parameters of the
stochastic volatility process were used to compute the theoretical price of each option.
As for the Black-Scholes model, the calibrated volatility, which has the minimal squared errors
between the market and model price of the options within the whole dataset, is used to attain the
theoretical price of each option in the sample.

5.3TheComparisonoftheHestonModelPricesandtheMarketPrices

The most basic way to see how well the prices of the options calculated with BS and the Heston
model capture the option prices in the market is to compare the prices visually. However, one
cannot see from plots how accurate the prices are, as the price differences are mainly in small
decimals, making it hard to make a judgment. As seen from figure 5.1, both Heston model and BS
manage to imitate the market prices of the SPX options quite well. In fact, one cannot see the
differences from the plot as the graphs are overlapping.

Figure 5.1. The comparison of SPX options market prices and model prices. The prices are
obtained from the 24.04.09 dataset.


Figure 5.2. The comparison of VIX options market prices and model prices. The prices are
obtained from the 24.06.09 dataset.


The differences of the prices become more evident within the VIX options (Figure 5.2) However, a
clear judgment cannot be done. From the figures 5.1 and 5.2 it may appear that options with shorter
time-to-maturities are priced more correctly. This can be due to calibrating the options across all
maturities within one dataset. As there are more options traded with shorter maturities, hence, more
options with shorter time-to-maturities are included in the calibration. Thus, calibration puts more
weight on options with shorter expiration dates, pricing them more correctly.
Another disadvantage of comparing prices is that prices have absolute terms, so they cannot be
easily compared across maturities as well as within different datasets or types of options. Therefore,
different mathematical calculations are used to capture the differences between the prices. Two of
them, average absolute error as a percentage of the mean price (APE) and the average relative
percentage error (ARPE) are discussed in the next section.
Still a clear judgment of the fitness of the models by taking the prices as the only criteria cannot be
made. As a result, a better way is to compare the implied volatility surfaces in order to compare the
models visually. Hence, the IVS of the market is compared to the IVS backed out from the option
prices calculated by different models in later sections.

5.4AveragePercentageErrorandAverageRelativePercentageError

Having calibrated the Heston models parameters, statistical measures are carried out to reveal
Heston model`s forecasting abilities. The average absolute error as a percentage of the mean price
(APE) is a quantity used to measure how close the outcomes of the model are to the empirical
outcomes. The mean APE is given by
APE =
1
Mcun Mukct pccs

| Mukct pcc-ModcI pcc|
Numbc o] Mukct pccs
optons
(5.3)
Another measure used is the average relative percentage error (ARPE), specified as
ARPE =
1
Numbc o] Mukct pccs

|Mukct pcc-ModcI pcc|
Mukct pcc
optons
(5.4)

The APE (the average absolute pricing error) is the sample average of the absolute difference
between the market price and the model price for each call in the testing sample period. The ARPE,
(the average relative percentage error) is calculated by taking the market price minus the theoretical
price, divided by the market price, and divided by number of options. (Cont & Kokholm 2009) The
APE and ARPE calculations have been carried out for both the SPX options and VIX options.
Four different comparisons are done:
Calibrated BS SPX option prices and the SPX options market prices
Calibrated Heston model SPX option prices and the SPX options market prices
VIX options with VIX option calibration (VIXVIX Heston prices) and the VIX options
market prices
VIX options with SPX option calibration (VIXSPX Heston prices) and the VIX options
market prices
The APE and ARPE are calculated within one dataset. Next, within each dataset the options having
the same time-to-maturity are grouped together. For each group of options the calculations of the
APE and ARPE are carried out. To see whether the models behave differently across moneyness,
the pricing errors are calculated separately for ITM and OTM options.

5.4.1TheAPEandARPEoftheSPXoptions

First, the Heston model`s performance is compared to BS to show that the Heston model is better at
capturing the market prices of plain vanilla options then BS. The BS calculations are carried out
using the SPX options only.
The average APE across all sample period (Table 5.2) has an average of 1.82 % for the Heston
model, and 16.63% for the BS model. The average ARPE across all sample period is approximately
13.95 % for the Heston model, and 73.34 % for the BS model. Looking across the whole sample
period, Heston's option-pricing model tends to perform better than BS across all maturities in the
sample period (Appendix Table 8.1). Evidently, the Heston model is better at pricing SPX options
than the BS model.
It is known from the literature (Gatheral 2006) that the Heston model tends to perform worse in
short term, and as a result one would expect the APE and ARPE to be higher for shorter time to
maturities. It should, however, be pointed out that this expectation was not fulfilled. This could be
due to the calibration, as the calibration is carried out for all the maturities within a dataset at the
same time. As the collected datasets generally have more data in shorter maturities, the calibration
improves the shorter maturities to a greater extent than the longer time-to-maturity options. Had the
calibration been carried out by weighting the dataset according number of options within each
maturity, a different scenario would have been obtained.

Table 5.2. The average APE and ARPE for SPX option prices. Calculations are carried out for
the sample period starting 24.04.09 ending 14.07.09. The averages are taken from Appendix table
8.1.


Table 5.3. The average APE and ARPE for SPX option prices divided into ITM and OTM
options. Calculations are carried out for the sample period starting 24.04.09 ending 14.07.09. The
averages are taken from the Appendix table 8.2.


Results show that the Heston model has the tendency to misprice OTM calls more than ITM calls.
Looking at the average APE in Table 5.3, the OTM options are approximately 4 times more
mispriced than the ITM options. The average ARPE is portraying a similar picture, the ARPE in
this case is at least 5 times worse for the OTM options than for the ITM options. Results across the
whole sample period show that the Heston model is pricing mostly ITM better across all maturities
in the sample period (Appendix Table 8.2). Yet, across the sample period the OTM option prices
outnumber the ITM option prices, the OTM option prices perform on average worse than ITM
options.
SPXHestonprices SPXBSprices
APE ARPE APE ARPE
1,82% 13,95% 16,63% 73,34%
SPXHestonprices
ITM OTM
AverageAPE AverageARPE AverageAPE AverageARPE
1,126% 3,058% 4,104% 16,883%

5.4.2TheAPEandARPEoftheVIXoptions

As a way of analyzing the general fitness of the Heston model`s ability to price a set of standard
vanilla call options against volatility derivatives, an average APE and ARPE are calculated across
the whole sample period for VIX options and compared to the results of the SPX options. The
pricing errors of VIXVIX Heston prices show how good the Heston model is at capturing VIX
option prices or volatility options in general. The pricing errors of VIXSPX Heston prices show,
whether the parameters acquired from SPX options calibration could be used to capture the prices
of VIX options data.
Using the Hestons model to price VIX options with parameters acquired from VIX calibration
yields an APE and ARPE of 16.35% and 39.87%, respectively. Without a doubt, the Heston model
is clearly more able to imitate the SPX options market prices.
Table 5.4. The average APE and ARPE for VIX option prices. Calculations are carried out for
the sample period starting 24.06.09 ending 14.07.09. The averages are taken from Appendix table
8.3.

Using, SPX options calibrated parameters to price VIX option prices decreases Hestons model`s
efficiency as APE increases from 16.35% to 29.69% and ARPE increases from 39.87% to 53.14%.
In table 5.4 clearly shows that the parameters obtained by calibrating SPX options are not suitable
for pricing VIX derivatives. In other words, it can be assumed that the same parameters can not be
used for pricing volatality derivatives when calibrating Heston models parameters from standard
vanilla options.This is evident, as APE and ARPE approximately double for the VIXSPX Heston
prices compared to VIXVIX Heston prices.
In addition, the APE and ARPE for ITM and OTM calls for the VIX options is examined. Once
again, results show that the Heston model has the tendency to misprice OTM calls more than ITM
calls for VIXVIX Heston options as well as for the VIXSPX Heston options (Table 5.5). The OTM
options are approximately 3 times more mispriced than the ITM options in terms of APE. The
VIXVIXHestonprices VIXSPXHestonprices
AverageAPE AverageARPE AverageAPE AverageARPE
16,35% 39,87% 29,69% 53,14%
average ARPE for the corresponding dataset is approximately 6 times higher for OTM option prices
in comparison to the ITM option prices.
All in all, the APE and ARPE calculations indicate that the Heston model might not be good
enough for pricing volatility options, and that OTM options are slightly more mispriced than the
ITM options in case of the plain vanilla options as well as VIX options. However, the Heston model
is an improvement from the BS constant volatility world.
Table 5.5. The average APE and ARPE for VIX option prices divided into ITM and OTM
options. Calculations are carried out for the sample period starting 24.06.09 ending 14.07.09. The
averages are taken from the Appendix table 8.4 & table 8.5.


5.5 The Implied Volatility Surface of the Heston Model in Comparison to the
ImpliedVolatilitySurfaceoftheMarket

In the figures 5.1 and 5.2 the Heston model seems to capture the market price evolution. However,
this conclusion in itself does not guarantee market practitioners a perfect implied volatility fit of
theoretical models in comparison to the market implied volatility. This is why implied volatilities
are used when comparing across models efficiency.

5.5.1TheImpliedVolatilitySurfaceofSPXOptions

Heston model has gained popularity because of its improvement from the BS model. The implied
volatility surface backed out from the prices calculated by the BS model is flat and does not fit the
market IVS.The IVS of the market SPX options shows a decreasing pattern, as previously
VIXVIXHestonPrices
ITM OTM
AverageAPE AverageARPE AverageAPE AverageARPE
6,245% 6,880% 19,021% 39,207%
VIXSPXHestonPrices
ITM OTM
AverageAPE AverageARPE AverageAPE AverageARPE
17,450% 18,951% 39,503% 58,830%
Figure 5.3. The comparison of the Heston model IVS and the SPX market IVS. The Heston
and the market implied volatilities plotted against moneyness and days to maturity. The left hand
side is the ITM area and the right hand side is the OTM area. Panel (a): The SPX data for
24.04.06 with time-to-maturity of 55, 144, 234 and 325 days. Panel (b): The SPX data for 04.06.06
with days to maturity of 15, 104, 194 and 284 days.


0.4
0.6
0.8
1
1.2
1.4
0
200
400
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Days to maturity
Moneyness
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
(a)
(b)
Figure 5.4. The comparison of the Heston model IV and the SPX market IV. Heston and the
market implied volatilities plotted against moneyness and days to maturity.


0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=15days
marketSPX Hestonmodel
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=30days
marketSPX Hestonmodel
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=35days
marketSPX Hestonmodel
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=55days
marketSPX Hestonmodel
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=234days
marketSPX Hestonmodel
0
0,2
0,4
0,6
0,8
1
0,5 0,7 0,9 1,1 1,3
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
moneyness
T=325days
marketSPX Hestonmodel
explained more in depth in section 2.8.2.However, when plotting the IVS of the SPX option market
prices and of the Heston model into a 3D plot it becomes apparent that the Heston model is
performing relatively well. This has been illustrated in figure 5.3. The market implied volatility is
lifted up by 10 volatility points. In this illustration, it is evident that the Heston model manages to
capture the market implied volatility better as the time to maturity increases. The excel charts make
it clear how the Heston model IV overlaps with the market IV as the time-to-maturity increases.

5.5.2TheImpliedVolatilitySurfaceofVIXOptions

Losses in the S&P 500 index are typically followed by high levels of the VIX, therefore, OTM call
options on the VIX provide protection against market crashes. Hence, the OTM call option writer
takes on extra risk and charges compensation for taking the additional risk. This can be compared to
the action of an OTM put writer on the S&P 500 index, who in a similar way charges compensation
for the additional risk. Therefore, as opposed to the downward sloping skew observed in the S&P
500 put options, the skew for VIX OTM call options seems to be upward sloping (positive
skew).(Sepp 2008 a) As can be seen from the term structures of the IVS backed out from VIX
options market prices, the OTM options show an upward sloping skew (Figure 5.7 top panels). On
the other hand, the ITM call options show a downward sloping skew, indicating that the OTM VIX
put option writers also might have some extra risk. All in all, the IVS of VIX options has U-shape
when the data for ITM options are available. Thus, whether the correlation of VIX with its volatility
is positive or zero remains a question. From the figure 5.5 it seems that VIX is positively correlated
with its standard deviation. As the level of VIX goes up, the volatility of VIX increases. From the
distribution of the VIX log-returns, one can see that they are right-skewed (Figure 5.6 and Table
5.6). This can point to a fact that there is a positive correlation. However, the IV skews plotted
against moneyness in a logarithmic scale show a symmetric smile (Figure 5.8 top panels). This can
be an indication of a zero correlation (Romano & Touzi 1997, Lee 2005). On the other hand, there
are other factors that should be taken into consideration, for example, changing from physical
measures to risk-neutral probability measures. As a result, a clear-cut conclusion cannot be done.

The IV skews backed out from the VIX options market prices and the IV skews of the VIXVIX
Heston prices are compared. The comparison shows that the Heston model has difficulties in
capturing the IVS of the volatility options (Figure 5.7, Figure 5.8 and Appendix A.2).

One difference is that the market IV skew shows an upward sloping skew for the OTM options, but
VIXVIX Heston IV skew shows a downward sloping skew at the same place (Figure 5.7). Another
difference is that the market IV skew displays an inconsistent pattern in taking convex or concave
shape. Occasionally, the market IV skew can have a combination of convex and concave shapes
within a maturity. The VIXVIX Heston implied volatilities show a concave upward sloping skew
when time-to-maturity decreases. As the time-to-maturity increases the VIXVIX Heston IV skew
becomes convex and downward sloping.

One similarity between the VIXVIX Heston and the market IV skew is that both show the highest
IV skew for the shortest maturity option and the lowest for the longest maturity option. It seems that
the market IV skew flattens out as the time-to-maturity increases, similarly to the SPX IV skew.
The VIXVIX Heston IV skews appear to be parallel for the shortest maturity option and the longest
maturity options. As mentioned before, the VIXVIX Heston IV skew tends to have concave shape
for shorter time-to-maturity options. Therefore, one of the explanations of this behavior can be the
intension to capture the most upward sloping IV skew of the market.

The comparison of the IV skew of the VIXSPX Heston model to the other two VIX IV skews
shows that using SPX parameters does not capture the VIX market IV skew at all. From the
Appendix figure 8.6 and 8.7 it can be assumed that the IV skews for the VIXVIX Heston and the
VIXSPX Heston behave rather similarly. At least it seems that as the time-to-maturity increases the
VIXVIX Heston and the VIXSPX Heston IV skews converge to the same level. As for the
comparison with the market IV, the VIXSPX Heston IV skew seems to go rather opposite direction
from the market IV skew. One interesting phenomenon is that all three IV skews seem to cross at
one point.

To summarise this chapter, it is evident that the Heston model is relatively good at replicating the
prices and IVS of SPX options. In contrast, the Heston model fails to price and capture IVS of the
VIX options, or in other words, volatility derivatives. It is clear that the parameters obtained from
SPX options prices cannot be used for pricing VIX options.

Figure 5.5. The comparison of VIX with its yearly standard deviation.


























0
50
100
150
200
250
volatility
ofVIX
VIX
Figure 5.6. Panel (a): Normal and kernel estimated densities of VIX daily log-returns 2002-
2009, panel (b): Log-normal and kernel estimated densities of VIX daily log-returns 2002-
2009.

Table 5.6: S&P500 index daily log-returns 2002-2009 statistics, using a statistics program
Eviews.

EVIEW
Mean 0.000145
Median -0.004016
Maximum 0.496008
Minimum -0.299872
Std.Dev. 0.061238
Skewness
0.568359
Kurtosis
7.574535
JarqueBera
Probability 1751.558
Observations 1892
0
1
2
3
4
5
6
7
8
9
0,3 0,2 0,1 0 0,1 0,2 0,3 0,4 0,5
logreturns
(a)
VIXreturns Normaldensity
10
5
0
0,3 0,1 0,1 0,3
logreturns
(b)
VIXlognormaldensity Lognormaldensity

Figure 5.7. Term structures of the IV skews backed out from VIX call options by strike and
option expiry. The left panels are showing the term structure of IV from the 24.06.09 dataset, the
right panels are showing the term structure of IV from the 09.07.09 dataset. The top panels are for
the term structure of the IV backed out from VIX options market prices, the middle panels are for IV
backed out from the VIXVIX Heston, the lower panels are for the IV backed out from VIXSPX
Heston prices.

Figure 5.8. Term structures of the IV skews backed out from VIX call options by strike and
option expiry in log-scale. The left panels are showing the term structure of IV from the 24.06.09
dataset, the right panels are showing the term structure of IV from the 09.07.09 dataset. The top
panels are for the term structure of the IV backed out from VIX options market prices, the middle
panels are for IV backed out from the VIXVIX Heston, the lower panels are for the IV backed out
from VIXSPX Heston prices.

6.The Effects of Altering Parameters in the
Heston Model

One of the goals of this thesis is to try to examine the behavior of the spot price process of the
Heston model according to the changes in parameters. A handy way to investigate it is to use the
effects of the parameters on implied volatility surface. The effective use of the stochastic volatility
model depends on the initial parameters and calibration of the parameters. The calibration process is
explained in section 5.2. At first, it can be useful to understand how each parameter influences the
option prices. The following section will analyse the effects of the Heston model`s parameters on
the IVS. This is based Heston`s own findings (1993).
The selection of parameters is clearly very important when working with stochastic volatility
models. Changing the correlation parameter has an impact on the option prices calculated with the
Heston model. Thus, for a negative correlation, the prices of OTM options are lower, and prices of
ITM options are higher than prices from the BS model and vice versa for a positive correlation. It is
known that the smile of the implied volatility surface is controlled by three parameters: The
correlation coefficient between the asset price and volatility process p, the mean reversion speed
and the volatility of volatility p. With correctly chosen parameters the stochastic volatility model
appears to produce a rich variety of pricing effects compared to BS. The BS formula produces
almost identical prices to stochastic models when the option is at-the-money. According to Heston,
options are quite often traded when they are near-the-money, hence for practical purpose the Black-
Scholes model works quite well. Nevertheless, using the Heston model the parameters can be fit to
match the kurtosis and skewness of the return distribution much more closely than using the Black
Scholes model. In the following section it is shown how the Heston model captures the implied
volatility surface by investigating the parameter stability and altering the parameters.



6.1ParameterStability

It would be convinient if the Heston model would have constant parameters. However, in practice
some variation is certainly present.
Looking at the SPX options datasets across the whole sample period (Table 6.1) reveal the initial
volatility has an average of 29% and standard deviation of 3.76%, being the most stable parameter
across the whole sample period. The parameter that seems to fluctuate most is the mean reversion
speed, with an average of 2.98 and a standard deviation of 251.5%. However, it should be noted that
the mean reversion speed is not expressed in percentage terms but in absolute terms. Hence, it can
be harder to make a clear judgment of the parameters stability. The mean reversion speed is
expressed in a different scale in comparison to the initial volatility, long-run volatility, correlation
coefficient and the volatility of volatility parameters. It implies that the mean reversion speed
parameter is not comparable to the rest of the parameters. Finally, it should be kept in mind that the
variations in mean reversion speed can vary greatly without having a vast impact on the value of the
option. The long-run volatility has an average of 39.8% and a standard deviation of 20.5%. The
volatility of volatility has an average of 27.9% and varies between 33.11 % and 134.5% with a
standard deviation of 72.5%. The parameter has an average (-0.86) and is more or less a stable
parameter in the Heston model with a standard deviation of 7.5%.
As far as the VIX options dataset is concerned (Table 6.2), the picture seems more or less the same.
The average initial volatility for this data is approximately 23.4%. The standard deviation of initial
volatility parameter is 3.9%, which is approximately 2% higher than of the SPX options. The mean
reversion speed has an average value of 7.32 and a standard deviation of 262%. The long-run
volatility level is the most stable parameter for the VIX options with a standard deviation of 0.61%
and an average of 34.65%. The average volatility of volatility is 130.66% and the standard deviation
is 26.17%.
Comparing the outcomes of SPX and VIX options, it can be seen that the biggest difference is in the
volatility of volatility parameter. The average for the VIX options is approximately twice as high
as the average of SPX options. Mean reversion speed differs greatly as well within the VIX and
SPX option calibrations. It becomes apparent in later sections that the mean reversion speed and the
volatility of volatility are affecting the volatility process in a similar fashion, but in opposite ways.
Hence, the higher value offsets the impact of the higher value for the VIX options.
The parameters obtained from the calibrations may not have any economic meaning, since the
Heston model requires unrealistically high parameters in order to generate volatility smiles that are
consistent with those observed in option prices with short times to maturity (Hafner 2005).

Table 6.1. The obtained parameter values for the Heston model calibrated with SPX options
data across the whole sample period.





SPXoptions
Date Initialvolatility Meanreversionspeed Longrunvolatility Volatilityofvolatility Correlationcoefficient
24042009 35,79% 2,51336 39,86% 89,36% 0,75033
01052009 34,01% 2,31790 38,03% 67,41% 0,89247
05052009 29,93% 2,63217 34,60% 45,88% 0,95255
06052009 32,83% 1,02790 42,49% 60,92% 0,83075
12052009 25,82% 0,05176 120,80% 33,11% 0,74866
14052009 33,87% 2,83457 35,09% 83,56% 0,84920
19052009 28,57% 0,63216 42,02% 47,25% 0,82439
27052009 29,42% 6,63279 31,70% 115,47% 0,86774
03062009 21,22% 5,27395 27,98% 37,32% 0,96243
04062009 30,47% 2,58222 35,85% 99,93% 0,77049
24062009 31,80% 1,58252 36,19% 64,39% 0,95960
26062009 23,52% 4,43691 31,33% 93,34% 0,77933
29062009 29,27% 4,56689 31,20% 94,28% 0,87817
01072009 27,33% 1,74777 35,29% 65,99% 0,93415
06072009 26,00% 1,11319 34,40% 41,11% 0,90799
09072009 31,48% 1,60796 35,11% 62,97% 0,91221
10072009 28,87% 10,40813 29,48% 134,52% 0,75331
14072009 27,18% 1,76426 36,36% 68,31% 0,91236
Average 29,30% 2,98480 39,88% 72,51% 0,86034
Stdev 3,77% 251,58% 20,57% 27,93% 7,52%
Table 6.2. The obtained parameter values for the Heston model calibrated with VIX options
data across the whole sample period.


6.2TheEffectsofAlteringParametersintheHestonModelfortheSPXData

In this section the effects of the changes of five different parameters in the Heston model on implied
volatility surface of SPX options are discussed. Those five parameters are initial variance, mean
reversion speed, long-run variance, volatility of volatility and correlation coefficient between spot
price and the volatility. For example, a higher volatility o
t
in the Heston model raises the prices of all
options the same way as it does in the Black-Scholes model. Hence, raising the o
t
increases the implied
volatilities.

The data and the parameters from calibrations of SPX options are used to make the illustrations of
the implied volatilities comparable to the ones in the market. For the simulations of the prices of
SPX options and the implied volatilities, a set of strike prices starting from $300 increasing by $50
up to $2700 are used. The moneyness is defined as the spot divided by the strike. The spot of $860
and four different maturities of options with corresponding futures prices are taken from the dataset
of 24.04.09 (Table 6.3). The default set of parameters are chosen to be the average of the
parameters (Table 6.4) obtained from the calibrations of 18 different datasets from 24.04.09 up to
14.06.09 (Table 6.1).
VIXoptions
Date Initialvolatility Meanreversionspeed Longrunvolatility Volatilityofvolatility
24062009 26,37% 8,5106 34,26% 141,33%
26062009 22,14% 7,6797 34,48% 135,15%
29062009 18,97% 8,9508 33,95% 143,65%
01072009 26,61% 3,2498 33,99% 86,65%
06072009 23,57% 6,2307 34,61% 122,16%
09072009 27,32% 4,3263 35,18% 103,48%
10072009 25,85% 8,1739 35,12% 141,98%
14072009 16,69% 11,4766 35,67% 170,87%
Average 23,44% 7,3248 34,66% 130,66%
Stdev 3,90% 264,38% 0,61% 26,17%

Table 6.3
futures pr

Daystoma
Futures

Table 6.4.
maximum
calibrations

6.2.1Curre

The curren
reversion s
but not the
displayed.
calibration
changes re
calibration
therefore s
implied vo
comparison
(Heston 19
of-thumb s

6.2.2Long

The volatili
increases th
Average
Max
Min
Days to m
rices
aturity
55
$8
Default se
parameter
s across the
entorInitia
nt or initia
speed determ
e shape of t
The param
ns (Table 6.
ealistic: the
ns are used
shifts the vo
olatility sm
n to the inf
993). In figu
states that sk
grunVolati
ity process f
he prices of o
2
3
2
Initialvolatil
maturities o
5 14
856,8 $8
et of param
represents
e whole sam
alVolatility
al volatility
mined by .
the smile. In
meters used f
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e average,
to plot IV
olatility smi
mile down.
fluence of t
ure 6.2 the
kew slopes
ility
fluctuates ar
options. On
29%
36%
21%
ity Meanrev
of SPX op
44
852,9
meters for s
s the minim
mple period
y
is pulled
. Altering th
n figure 6.2
for illustrati
nly paramete
the maxim
skews on e
ile upwards
The influen
the long-run
smile or sk
decay with
round the lon
figure 6.3,
2,98
10,41
0,05
versionspeed
ptions trade
234
$849,8
simulation
mum and m
d (Table 6.1
towards a
he initial vo
2 the effect
ions are the
er that is c
mum and th
each graph.
. Lowering
nce of the
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ng-run mean
the implied
8
1
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d Longrunva
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325
$847,4
of implied
aximum pa
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long-run m
olatility chan
of initial v
e average pa
changed is t
he minimum
. Higher ini
initial vola
current vo
is determin
as T increa
pproximatel
n of . An
d volatilities
40%
121%
28%
ariance Volati
04.09 with
4
d volatilitie
arameter va
mean of vo
nges the hei
volatility to
arameter va
the initial v
m initial v
itial volatili
atility has th
latility on
ned by the
ases. In part
ly as . (L
increase in
s of the Hes
7
13
3
ilityofvolatil
their corre
s. Each mi
alue obtaine
olatility ,
ight of the s
the shape o
alues acquir
volatility. T
olatility va
ity lifts the
he effect of
SPX option
mean rever
ticular, a po
Lee 2005)
the average
ston model
73%
35%
33%
Correlatio ity
esponding
nimum and
ed from 18
with mean
smile curve
of the IV is
red from 18
To keep the
alues of 18
prices and
f pulling the
n prices in
rsion speed
opular rule-
volatility
prices with
0,86
0,75
0,96
oncoefficient
g
d
8

n
e
s
8
e
8
d
e
n
d
-

h
6
5
6
t
different long-run volatilities are plotted. Higher long-run volatility increases the prices and
therefore the implied volatilities. Lower long-run volatility has the effect of decreasing the implied
volatilities. Whether the initial volatility is pulled towards the long-run volatility quickly or slowly is
determined by the mean reversion speed. As can be seen from figure 6.3, the longer the time-to-maturity, the
more the IV smile is flattened and pulled towards the long-run volatility. Spot returns over long periods will
have asymptotically normal distributions, with volatility per unit of time given by o . Therefore, the BS
model should tend to work well for long-term options (Heston 1993). However, the IV from option prices
may not equal the volatility of spot returns given by the "true" process.

Figure 6.2. The effects of initial volatility on IV skew. The IV skews of SPX options on different
time-to-maturities of 55, 144, 234 and 325 days are illustrated. The IV with average initial volatility
of 29%, the IV with the maximum initial volatility of 36% and the IV with minimum initial volatility of
21% are compared.

Figure 6.3 The effects of long-run volatility on IV skew. The IV skews of SPX options on
different time-to- maturities of 55, 144, 234 and 325 days are illustrated. The IV with average long-
run volatility of 40%, the IV with the maximum long-run volatility of 121% and the IV with long-run
volatility of 28% are compared.



6.2.3MeanReversionSpeed

As mentioned earlier, the mean-reversion speed determines how fast is the volatility process pushed toward
a long-run mean of o . Changing the mean reversion speed has an evident impact, i.e. change in the
mean reversion speed shifts the center of the volatility smile. The mean reversion speed represents
the clustering of the volatility. The clustering of the volatility process has also been observed in the
market, as large price movements are more likely to be followed by large price movements.
Furthermore, the influence of mean reversion can be compensated by a stronger volatility of
volatility. The mean reversion speed shows how much relative weight does the current volatility have
compared to the long-run volatility on option prices. When mean reversion speed is positive, the volatility
has a steady
higher than
prices and
the long-ru

Figure 6.4
different tim
reversion s
mean reve

6.2.4Volat

The parame
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tilityofVol
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he implied v
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latility
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with the m
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latility of vo
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x, Ingersoll,
PX options,
(Figure 6.4)
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and 325 day
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and Ross 19
higher me
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ys are illust
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The IV ske
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y would be
V.
ews of SPX
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f the distribu
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OTM option
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6.2.5TheC

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Figure 6.5
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ation param
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gure 6.9). C
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ger spot price
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re 6.10b). R
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ases the pric
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ghtly below
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ty raises far
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atility of vol
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odel can pro
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with lower v
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ht tail and p
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e IV of ITM
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where

variety of pri
ts of stochas
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llustrated on
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n results in
of the spot
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turn creates
he prices of
M options is
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with the spot
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.
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figures 6.9
Figure 6.
skews of S
The IV wit
135% and




n increasing
dom volatilit
oney options
TM options.
ewness. Pos
ns. Therefore
y. By alterin
shift and im
9 and 6.10.
.5. The eff
SPX options
h average v
the IV with
the volatility
ty is associat
s. In contrast
This is due
itive skewne
e, it is essent
ng the correl
mpact the sh
fects of vo
s on differe
volatility of
volatility of
y of volatilit
ted with incr
t, in figure 6
to the negat
ess is associa
tial to choose
lation in t
hape of imp
olatility of
ent time-to-m
volatility of
f volatility of
ty increase
reases in the
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tive correlati
ated with inc
e properly th
the Heston m
plied volatili
volatility o
maturities o
73% , the
f 33% are c
s the kurtosi
prices of far
that affec
ion of volati
creases in th
he correlation
model the sk
ity surface.
on IV skew
of 55, 144, 2
IV with the
ompared.
is of spot re
r-from-the-m
cts the IV of
ility with the
he prices of O
n coefficient
kewness of
(Heston 199
w with ave
234 and 32
maximum
turns, not th
money option
f the OTM o
e spot return
OTM option
t as well as t
f the distribu
93) This can
rage =-0,
25 days are
volatility of
he skewness.
ns relative to
options more
ns causing a
ns relative to
the volatility
ution would
n be seen in
86. The IV
e illustrated.
volatility of
.
o
e
a
o
y
d
n
V

f

Figure 6.6. The effects of volatility of volatility on IV skew with =1. The IV skews of SPX
options on different time-to-maturities of 55, 144, 234 and 325 days are illustrated. The IV with
average volatility of volatility of 73% , the IV with the maximum volatility of volatility of 135% and
the IV with volatility of volatility of 33% are compared.




















Figure 6.7. The effects of volatility of volatility on IV skew with =0. The IV skews of SPX
options on different time-to-maturities of 55, 144, 234 and 325 days are illustrated. The IV with
average volatility of volatility of 73% , the IV with the maximum volatility of volatility of 135% and
the IV with volatility of volatility of 33% are compared.

Figure 6.8. The effects of volatility of volatility on IV skew with =0 and moneyness is
defined as log(K/F) The IV skews of SPX options on different time-to-maturities of 55, 144, 234
and 325 days are illustrated. The IV with average volatility of volatility of 73% , the IV with the
maximum volatility of volatility of 135% and the IV with volatility of volatility of 33% are compared.













Figure 6.9. The effect of on the skewness of the density function. Source: Moodley (2005)

Figure 6.10. The effect of on the skewness of IVS. Panel (a): o
t
2
=29%, =2,98, o
2
= 4u%,
=73%, =0,9. Panel (b): o
t
2
=29%, =2,98, o
2
= 4u%, =73%, =0 and moneyness is on log-
scale. Panel (c): o
t
2
=29%, =2,98, o
2
= 4u%, =73%, =-0, 9.


(a)


6.3TheEffectsofAlteringParametersintheHestonModelfortheVIXOptions


In this section the effects of changes of the Heston model parameters on IVS of VIX options are
discussed. In VIX options calculations the parameter for correlation between the volatility and stock
(c)
(b)
price does not exist, therefore only the effect of initial volatility, mean-reversion speed, long-run
volatility and volatility of volatility are shown.

The data and the parameters from calibrations of VIX options are used to make the illustrations of
the implied volatilities realistic. For the simulations of the prices of VIX options and the implied
volatilities a set of strikes from 10% to 100% of VIX are used. The moneyness is defined as the spot
divided by the strike. The spot of 29.18% and six different maturities of options with corresponding
futures prices are taken from the dataset of 24.06.09 (Table 6.5). The default set of parameters are
chosen to be the average of the parameters (Table 6.2) obtained from the calibrations of 8 different
VIX options datasets from 24.06.09 up to 14.07.09 (Table 6.5).


Table6.5
DaystomaturitiesofVIXoptionstradedon24.06.09withtheircorrespondingfuturesprices

Daystomaturity
28 55 82 117 144 172
Futures
$30,9 $31,3 $31,65 $31,73 $31 $30,15

Table6.5
DefaultsetofparametersforsimulationofimpliedvolatilitiesoftheVIXoptions

6.3.1CurrentorInitialVolatility

In the Heston model of a volatility process, the current or initial volatility drifts toward a long-run
mean of volatility o , with mean-reversion speed determined by . Implied volatilities of VIX
options are plotted against the moneyness in figure 6.11. The parameters used are the average
parameter values acquired from 8 calibrations (Table 6.5). The only parameter that is changed is the
initial volatility. The average, the maximum and the minimum initial volatility values of 8
calibrations (Table 6.2) of VIX options are compared on each of the graphs. Higher initial volatility
lifts the prices and therefore moves volatility smile upwards. Intuitively, as then the volatility
process will end up being in a higher level on the day the VIX index is calculated, the VIX index is
Initialvolatility Meanreversionspeed Longrunvolatility Volatilityofvolatility
Average 23% 7,32 35% 131%
Max 27% 11,48 36% 171%
Min 17% 3,25 34% 87%
expected to be in higher level as well. The different levels of initial volatility seem to influence
mainly the left hand side of the IV skew, changing the curvature of the IV skew. The higher the
initial volatility level, the more likely IV skew takes a concave shape. The curvature of IV skew is
also influenced by the time-to-maturity of the option. IV skew is typically downward sloping and
convex for longer time-to-maturity options and becomes more concave and upward sloping as the
time-to-maturity decreases. This IV behavior is not consistent with the IV behavior seen in the
market (Figure 5.7). The market IV skew starts with a downward sloping convex skew for ITM area
and changes the direction and curvature near at-the-money.

6.3.2LongrunVolatility

The long-run volatility is the main factor in the Heston model determining the level of instantaneous
volatility of S&P500 index on the day VIX is calculated (the expiration day for the VIX option). The long-
run volatility is also the main factor when the expectation of the volatility in the next 30 days (VIX index) is
calculated using the equation (4.33). Hence, an increase in the average volatility
oError! Bookmork not JcincJ. increases the prices of options. In figure 6.12, the implied
volatilities of VIX options with different long-run volatilities are plotted. Higher long-run volatility
increases the prices and therefore the implied volatilities of the ITM VIX options. Lower long-run
volatility has the effect of decreasing the level of IV skew and changing the direction of the skew.
As can be seen from figure 6.12, the longer the time-to-maturity, the more the IV plot has an increasing left
hand side of the IV plot. This is the case when the initial volatility is lower than the long-run volatility.

6.3.3MeanReversionSpeed

As pointed out earlier, mean reversion speed accounts for the rapidness in changes of the volatility
process in the Heston model, higher mean reversion speed increases the weight of the long-run
volatility. In other words, the mean reversion speed determines how much the VIX index fluctuates.
If mean reversion speed is high then the probability of having extreme values of VIX index is low.
Consequently, it is less likely that the VIX index decreases dramatically, increasing the value of the
ITM options. On the other hand, the mean reversion speed seems to have an opposite effect on
OTM options as the likelihood of ending ITM is lower. Intuitively, a lower mean reversion speed
has an opposite effect. As illustrated in figure 6.13, the IV skew for the lowest has the lowest
value for the ITM area and the highest value in OTM area and vice versa for the highest . Another
detail is that if the initial volatility is higher than the long-run volatility, higher mean-reversion
would decrease the prices and IV no irrespective whether the option is ITM or OTM.

6.3.4VolatilityofVolatility

The effect of raising volatility of volatility on IV skew is illustrated on figure 6.14. It can be seen that raising
volatility of volatility lowers the IV of ITM options. On the contrary, increases the prices and IV of the
OTM options. If volatility of volatility is high then the probability for the VIX option to go far ITM or far
OTM is higher. In this case the correlation between the VIX index and its volatility process is assumed to be
zero. In the Heston model there is no process for the volatility of volatility itself. However, if is assumed to
be positive then higher volatility of volatility would also increase the possibility of the spot price being
higher. Therefore, implied volatilities would be skewed to the right. As discussed in section 5.5.2 VIX index
has zero or positive correlation with the volatility of VIX index. Hence, as is increased, the spot price is
predicted to go up as well. OTM options have bigger spot prices and therefore options with higher volatility
of volatility are more likely to have bigger spot prices.

To conclude this chapter, Monte Carlo simulations show that the Heston model creates a rich variety of
pricing and IV effects compared to the BS model. The parameters in the Heston model have slightly different
effects on the IV of SPX options than on the volatility options. As for the SPX options, the initial and long-
run volatilities determine the height of the IV skew. Mean reversion speed, volatility of volatility and
correlation coefficient change the shape of the IV skew. It is important to separate the effects of volatility of
volatility and the correlation coefficient. If volatility is uncorrelated with the spot return, then increasing the
volatility of volatility increases the kurtosis of spot returns, not the skewness. Skewness is associated with
the correlation coefficient. As for the VIX, the initial volatility parameter and the long-run volatility
parameter determine the value of the VIX not the volatility of the VIX. The volatility of the VIX index is
influenced by volatility of volatility as well as mean reversion. In other words, these parameters decide how
much the VIX index can fluctuate around its mean value.





Figure 6.11. The effects of initial volatility on IV skew of the VIX options. The IV skews of VIX
options on different time-to-maturities of 28, 55, 82, 117, 144 and 172 days are illustrated. The IV
with average initial volatility of 23%, the IV with the maximum initial volatility of 27% and the IV with
minimum initial volatility of 17% are compared.

Figure 6.12. The effects of long-run volatility on IV skew of the VIX options. The IV skews of
VIX options on different time-to-maturities of 28, 55, 82, 117, 144 and 172 days are illustrated. The
IV with average long-run volatility of 35%, the IV with the maximum long-run volatility of 36% and
the IV with minimum long-run volatility of 34% are compared.








Figure 6.13. The effects of mean reversion speed on IV skew of the VIX options. The IV
skews of VIX options on different time-to-maturities of 28, 55, 82, 117, 144 and 172 days are
illustrated. The IV with average mean-reversion speed of 7.33, the IV with the maximum mean-
reversion speed of 11.48 and the IV with minimum mean-reversion speed of 3.25 are compared.

Figure 6.14. The effects of volatility of volatility on IV skew of the VIX options. The IV skews
of VIX options on different time-to-maturities of 28, 55, 82, 117, 144 and 172 days are illustrated.
The IV with average mean-reversion speed of 131%, the IV with the maximum mean-reversion
speed of 171% and the IV with minimum mean-reversion speed of 87% are compared.




7. Conclusion

The purpose of this thesis was to give an overview of the stochastic volatility models, the Heston
model in particular, with applications to volatility derivatives. In other words, it was shown how
good the Heston model was in pricing volatility options (VIX options) in comparison to pricing
plain vanilla options (SPX options). This thesis was divided into two parts. The first part focused
more on the theoretical side of the Heston model and volatility derivatives. The second part focused
on analyzing and discussing the performance of the Heston model by comparing Heston model`s
ability to capture the prices of SPX options as well as VIX options.

The quintessential Black-Scholes model was explained. First, the Wiener process and its extension,
geometric Brownian motion, was introduced. Black-Scholes model assumes geometric Brownian
motion, in order to avoid stock prices going negative. The principle behind the BS model is that, it
is possible to create a hedged position with an expected return by
the risk-free interest rate, requiring a continuous hedging. The assumptions of the BS model were
presented and some of them were shown not to hold in the real market. More specifically, the log-
normality and constant volatility of the returns were tested empirically not to be satisfied. Using the
data from S&P500 it was shown that the distribution of returns of that index rejects normality. The
returns showed negative skewness and excess kurtosis. As for the volatility of the returns, 21-day
rolling-window of the standard deviation was calculated, displaying fluctuations in returns.
Furthermore, the volatility of S&P500 index showed signs of negative correlation with its index
value. Next, the concept behind the implied volatility of the options was introduced. It was shown
that options implied volatilities are observed to have a smile or a skew. Stochastic volatility models
have been launched to imitate the behavior of the IVS in market.
A brief history of stochastic models was written and one of them, the Heston model, was chosen to
be further investigated due to its popularity of use in the market. The main advantage of the Heston
model is that it allows for the asset and its volatility process to be correlated as well as allowing for
the volatility process to be mean-reverting and fits the market IVS. The Heston model has also been
proven to have flaws: its parameters have to be estimated and the calibration process is not trivial in
itself. In addition, the Heston model has been shown to not fit the IVS for shorter maturities. In this
thesis, the mixing solution introduced by A. Lewis was taken as an inspiration in calculating the
option prices using Monte Carlo simulation for the SPX options.
This thesis focused on volatility derivatives, therefore, an introduction to those instruments was
given. Those instruments have been recently launched by the traders in order to insure themselves
against volatility risk. Previously traders would use the exchange-traded standard futures and delta-
hedged option positions as a means to trade volatility. However, the purpose of these instruments is
to deal primarily with price risk. An alternative way to capture realized variance is to replicate the
variance by using a portfolio of vanilla options. This approach is known as the replicating strategy.
The idea behind replicating strategy is to construct a portfolio of options that is immune to stock
price movements and gives the expected payoff of the future realized variance at maturity.
Volatility derivatives are special instruments designed to depend only on the volatility process.
They have a payoff which depends on the variance of the underlying assets return over the life of
the volatility derivative, namely on the realized variance. A rapid growth of the market for options
on the realized variance has been seen in recent years. Different kind of volatility derivatives
include variance and volatility swaps, variance and volatility options and futures.
Furthermore, volatility has been treated as a distinct asset which can be packaged in an index
(volatility index). The most popular volatility index (VIX) was introduced by CBOE in 1993. The
VIX measures the implied volatility of S&P500 stock index options with time-to-maturity of 30
days and it is used as an indicator of market stress. Observations from market data indicate that
VIX starts to rise during market crash and lessens as investors become complacent. VIX futures and
options are designed to have a volatility exposure in a single, convinient package. Trading in VIX
futures contracts started in 2004 and trading in VIX option contracts began in February 2006. One
contract is on 100 times the index.

In the second part, the performance of the Heston model was studied in terms of prices and later in
terms of implied volatility. First, the plain vanilla option prices (SPX options) have been calculated
using the Heston model in order to investigate the fitness of the model. Second, the same procedure
has been carried out for the VIX options. The prices are calculated using Monte Carlo simulation
and fitted to the market using calibration. An attractive feature of Monte Carlo simulation is that it
can be applied to different kind of financial instruments and is therefore a widely used technique by
practitioners. In order to calculate option prices using the Heston model and the Monte Carlo
simulation method, the parameters in the Heston model had to be estimated for the SPX options.
Five parameters needed estimation in the Heston model: , o
2
,

o
t
2
, p, p. Whereas for VIX options
the p was excluded. The calibration was carried out by minimizing the sum of squared errors
between the market and the Heston model prices. In order to see whether the parameters for SPX
options could be used to price VIX options another set of VIX option prices were calculated using
the Heston model and the parameters obtained from SPX option calibration. First, the comparison
of the model prices and the market prices was done by plotting the prices on graphs. Differences in
prices became more apparent as time to maturity increased. As differences were minuscule in
prices, numerical investigations were needed. The prices were spelled out by calculating average
percentage errors and average relative percentage errors. The results were as expected for SPX
options, showing that the Heston model was able to replicate market prices relatively well in
comparison to BS model. The Heston model mispriced OTM more than the ITM options.
Nevertheless, the Heston model was much worse at pricing the VIX options. Yet, using SPX
options parameters to price VIX options approximately doubled the errors. Once again, the Heston
model seemed to price ITM VIX options more accurately than the OTM options.

In order to make a qualitative judgment of the model, a basic way is to compare implied volatility
surfaces. Therefore, from the calculated prices as well as for the market prices the implied
volatilities were backed out. Not surprisingly, the Heston model proved to be able to replicate
market IVS rather well. As time to maturity increased, the accuracy of the model improved. The
SPX options produced a downward sloping IV skew, implicating a negative correlation between
S&P500 index and its volatility. As for the VIX options the Heston model was inadequately
replicating market IVS. For the OTM options, the VIX options market showed an upward sloping
IVS, yet the IVS produced by the Heston model showed an opposite behavior. As for the ITM
options, the IVS results were inconsistent. All in all, the IV skew of the Heston model was taking an
opposite direction from the market IV skew. By using parameters from the SPX options, the
differences between the market and the Heston IVS were more evident. Next, the parameters
obtained from calibrations were scrutinized. The stability of Heston models parameters displayed
variation in the parameters, some more than others, but all in all the outcome was rather
inconclusive. Hereafter, by using the acquired parameters, the effects on the IVS were observed.
What was observed was that the initial volatility and long-run volatility shifted the IVS either
upward or downward. Mean-reversion speed shifted the center of the IVS and determined the
weights of initial and long-run volatility. The volatility of volatility parameter increased the far
OTM and far ITM option prices, but the skewness is affected by the correlation coefficient. As for
the VIX options, the effects of the parameters were different from the ones observed from the SPX
options IVS. The changes in the parameters seemed to determine whether the skew was downward
or upward sloping. The mean-reversion speed and the volatility of volatility seemed to change the
IVS in the same manner, having opposite effect depending whether the option is ITM or OTM.

A number of things have an effect on the pricing of VIX options. As the Heston model does not include
a lot of these factors, the performance of the Heston model in pricing the VIX options is not first-class.
Some of the main factors affecting VIX option pricing are as follows: mean-reversion of VIX, jumps in
the S&P500 index and in its volatility, and stochastic volatility of VIX. Another issue is that some of the
results are affected by the current financial crisis. All in all, for the majority of outcomes in this thesis,
one would expect similar results to those obtained when the market is less volatile.

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http://seekingalpha.com/article/68240-investigating-the-vix-s-p-500-correlation
http://finance.yahoo.com/
http://seekingalpha.com/article/68240-investigating-the-vix-s-p-500-correlation

Appendix

A.1.Expectation of the Realized Variance According To the Heston Model
As it is known in the Heston model variance satisfies the equation
Jo
t
2
= (o
t
2
-o
t
2
)Jt +po
t
Jw
2
(8.1)

By integrating the equation (3.8) from 0 to T the following equation is obtained
] Jo
t
2
= ] (o
t
2
-o
2
)Jt +
1
0
p ] o
t
JZ
2
1
0
1
0
(8.2)
After the expectations are taken
E|o
1
2
] -o
0
2
= o
2
I -E j] o
t
2
Jt
1
0
[ +E jp ] o
t
JZ
2
1
0
[ (8.3)
Using the properties of Wiener process, Ej] g(S)JZ = u
I
u
[, yields
E|o
1
2
] -o
0
2
= o
2
I - ] E|o
t
2
t
]Jt
1
0
(8.4)
If the above equation is differentiated with respect to T, it gives
E|o
2
1
] = (o
2
-E|o
t
2
]) (8.5)
Solving the first order linear differential equation provides
E|o
2
1
] = o
2
+c
-k1
c (8.6)
where c is some constant.
E|o
1
2
] = o
2
+c
-k1
(o
t
2
-o
2
) (8.7)
Integrating it from 0 to T yields
E|o
1
2
] =
1-c
-kT
k
(o
t
2
-o
2
) +o
2
(8.8)
As E|:
1
] is the total variance, the expected realized annualized variance is
1
1
E|o
1
2
] =
1-c
-kT
k1
(o
t
2
-o
2
) +o
2
(8.9)
A.2. Term structures of the implied volatility skews backed out from VIX call
options by strike and option expiry.
Figure 8.1. Term structures of the implied volatility skews backed out from VIX call options
by strike and option expiry. The left panels are showing the term structure of implied volatilities
from the 26.06.09 dataset, the right panels are showing the term structure of implied volatilities
from the 29.06.09 dataset. The top panels are for the term structure of the IV of VIX market prices,
the middle panels are for IV backed out from the VIXVIX data, the lower panels are for the IV
backed out from the VIXSPX data.

Figure 8.2. Term structures of the implied volatility skews backed out from VIX call options
by strike and option expiry. The left panels are showing the term structure of implied volatilities
from the 01.07.09 dataset, the right panels are showing the term structure of implied volatilities
from the 26.07.09 dataset. The top panels are for the term structure of the IV of VIX market prices,
the middle panels are for IV backed out from the VIXVIX data, the lower panels are for the IV
backed out from the VIXSPX data.



Figure 8.3. Term structures of the implied volatility skews backed out from VIX call options
by strike and option expiry. The left panels are showing the term structure of implied volatilities
from the 10.07.09 dataset, the right panels are showing the term structure of implied volatilities
from the 24.07.09 dataset. The top panels are for the term structure of the IV of VIX market prices,
the middle panels are for IV backed out from the VIXVIX data, the lower panels are for the IV
backed out from the VIXSPX data.

Figure 8.4. Term structures of the IVS backed out from VIX call options by strike and option
expiry in log-scale The left panels are showing the term structure of IV from the 26.06.09 dataset,
the right panels are showing the term structure of IV from the 29.06.09 dataset. The top panels are
for the term structure of the IV of VIX market prices, the middle panels are for IV backed out from
the VIXVIX data, the lower panels are for the IV backed out from the VIXSPX data.


Figure 8.4. Term structures of the IVS backed out from VIX call options by strike and option
expiry in log-scale The left panels are showing the term structure of IV from the 01.07.09 dataset,
the right panels are showing the term structure of IV from the 06.07.09 dataset. The top panels are
for the term structure of the IV of VIX market prices, the middle panels are for IV backed out from
the VIXVIX data, the lower panels are for the IV backed out from the VIXSPX data.


Figure 8.5. Term structures of the IVS backed out from VIX call options by strike and option
expiry in log-scale The left panels are showing the term structure of IV from the 10.07.09 dataset,
the right panels are showing the term structure of IV from the 14.07.09 dataset. The top panels are
for the term structure of the IV of VIX market prices, the middle panels are for IV backed out from
the VIXVIX data, the lower panels are for the IV backed out from the VIXSPX data.

Figure 8.6. The comparison of the IVS of the VIX call options by options maturity (market,
Heston model VIXVIX and Heston model VIXSPX) traded on 24.06.09. The red line indicates
the IV backed out from VIX call options market prices, the green line represents the IV backed out
from the Heston VIXVIX data, the blue line indicates the IV backed out from the Heston VIXSPX
data.

Figure 8.7. The comparison of the IVS backed out from the VIX call options by maturity
(market, VIXVIX and VIXSPX traded on 09.07.09. The red line indicates the IV backed out from
VIX call options market prices, the green line represents the IV backed out from the Heston VIXVIX
data, the blue line indicates the IV backed out from the Heston VIXSPX data.

A.3The APE and ARPE for SPX and VIX data

Table 8.1. The average APE and ARPE for SPX option prices. Calculations are carried out for
the sample period starting 24.04.09 ending 14.07.09. The APE and ARPE are calculated for each
maturity and for each dataset.







Table 8.2. The average APE and ARPE for SPX option prices divided into ITM and OTM
options. Calculations are carried out for the sample period starting 24.04.09 ending 14.07.09. The
APE and ARPE are calculated for each maturity and for each dataset.




Table 8.3. The APE and ARPE of VIXVIX Heston data and VIXSPX Heston data. Calculations
are carried out for the sample period starting 24.06.09 ending 14.07.09. The APE and ARPE are
calculated for each maturity and for each dataset.


Table 8.4. The APE and ARPE for VIXVIX Heston option prices divided into ITM and OTM
options. Calculations are carried out for the sample period starting 24.06.09 ending 14.07.09. The
APE and ARPE are calculated for each maturity and for each dataset.

Table 8.5. The APE and ARPE for VIXSPX Heston option prices divided into ITM and OTM
options. Calculations are carried out for the sample period starting 24.06.09 ending 14.07.09. The
APE and ARPE are calculated for each maturity and for each dataset.







A.4.The Sum of Squared Errors
The sum of squared errors in the table represents the average sum of squared errors per option
between the market prices and the prices obtained by the Heston model using the shown parameters.
Therefore, on average the price calculated by the Heston model differs from the market price
approximately by $1 per option (Table 8.6). For the VIX options the average difference is 24 cents
per option (Table 8.7). It appears that SPX options are priced worse than the VIX options. Yet this
is not the case as the spot price during the observed time was around $900 and VIX spot was on
average 28%.
Table 8.6. The sum of squared errors for SPX options.











SPXoptions
Date Sumofsquarederrors
24042009 0,283175438
01052009 1,114538335
05052009 0,304380956
06052009 0,451820611
12052009 5,970370717
14052009 0,050981919
19052009 1,150415734
27052009 0,794871228
03062009 0,278435982
04062009 1,715561511
24062009 0,463330066
26062009 0,17257193
29062009 0,296064159
01072009 2,920508456
06072009 0,54070523
09072009 1,343237247
10072009 0,346183321
14072009 1,004008632
Average 1,066731193
Stdev 141%
Table 8.7. The sum of squared errors for VIX options.

VIXoptions
Date Sumofsquarederrors
24062009 1,413262136
26062009 1,351452549
29062009 1,436525407
01072009 0,866547197
06072009 1,221640513
09072009 1,034845984
10072009 1,419839088
14072009 1,708737365
Average 1,306606280
Stdev 26,17%