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L5 Castagna and Mercurio
L5 Castagna and Mercurio
L5 Castagna and Mercurio
option pricing
www.risksouthafrica.com 39
cutting edge. option pricing
Maintaining the assumption of flat but stochastic implied Calculating the VV weights
volatilities, the presence of three basic options in the market makes We assume hereafter that the constant BS volatility is the ATM
it possible to build a portfolio that zeroes out partial derivatives up one, thus setting s = s2 (= sATM). We also assume that t = 0,
to the second order. In fact, denoting respectively by Dt and xi the dropping accordingly the argument t in the call prices. From (2),
units of the underlying asset and options with strikes Ki held at we see that the weights x1 = x1(K), x2 = x2(K) and x3 = x3(K), for
time t and setting CiBS (t) = CBS (t; Ki), under diffusion dynamics for which the resulting portfolio of European-style calls with
both St and s = st, we have by Itô’s lemma: maturity T and strikes K1, K2 and K3 has the same vega, ∂Vega/
3
∂Vol and ∂Vega/∂Spot as the call with strike K,8 can be found by
dC BS ( t; K ) − ∆ t dSt − ∑ xi dC iBS ( t ) solving the following system:
i=1
∂C BS 3
∂C BS
∂C BS ( t; K ) 3 ∂C iBS ( t ) ( K ) = ∑ xi ( K ) ( Ki )
= − ∑ xi dt ∂s i =1 ∂s
∂t i=1 ∂t
∂2 C BS 3
∂2 C BS
BS
∂C ( t; K ) 3
∂C iBS (t ) ( K ) = ∑ xi ( K ) ( Ki ) (4)
+ − ∆ t − ∑ xi dSt ∂s 2 i =1 ∂s 2
∂S ∂S
i=1
∂2 C BS 3
∂2 C BS
BS
∂C ( t; K ) ∂C iBS ∂s∂S0
( K ) = ∑ xi ( K )
∂s∂S0
( Ki )
3
(t ) i =1
+ − ∑ xi dσ t (2)
∂σ i=1 ∂σ Denoting by V(K) the vega of a European-style option with
2 BS 2 BS
1 ∂ C ( t; K ) 3 ∂ C i ( t ) 2
maturity T and strike K:
+ − ∑ x i ( dSt )
2 ∂S 2
∂S 2
∂C BS
i=1
( K ) = S0 e − r T T ϕ ( d1 ( K ))
f
V (K ) =
2 BS 2 BS ∂σ
1 ∂ C ( t; K ) 3 ∂ C i ( t ) 2 (5)
+ − ∑ x i ( dσ t ) ln
S0
(
+ r d − r f + 12 σ 2 T )
2 ∂σ 2 ∂σ 2 K
i=1
d1 ( K ) =
σ T
∂ 2 C BS ( t; K ) 3 ∂ 2 C iBS ( t )
+ − ∑ xi dSt dσ t where j(x) = Φ′(x) is the normal density function, and calculating
∂S∂σ i=1 ∂S∂σ
the second-order derivatives:
∂2 C BS V (K )
Choosing Dt and xi so as to zero out the coefficients of dSt, dst, (K ) = d1 ( K ) d2 ( K )
(dst)2 and dStdst,5 the portfolio comprises a long position in the ∂s 2 s
call with strike K, and short positions in xi calls with strike Ki and ∂2 C BS V (K )
(K ) = − d2 ( K )
short the amount Dt of the underlying, and is locally risk-free at ∂s∂S0 S0 s T
time t, in that no stochastic terms are involved in its differential6:
d2 ( K ) = d1 ( K ) − s T
3
dC BS ( t; K ) − ∆ t dSt − ∑ xi dC iBS ( t ) we can prove the following.
i=1
(3)
3
n Proposition 1. The system (4) admits a unique solution, which
= r d C BS ( t; K ) − ∆ t St − ∑ xi C iBS ( t ) dt is given by:
i=1
K K
V ( K ) ln K2 ln K3
x1 ( K ) =
Therefore, when volatility is stochastic and options are valued V ( K1 ) ln KK2 ln KK3
1 1
with the BS formula, we can still have a (locally) perfect hedge, K
provided that we hold suitable amounts of three more options to V (K ) ln KK ln K3
x2 ( K ) = 1 (6)
rule out the model risk. (The hedging strategy is irrespective of V ( K2 ) K
ln K2
K
ln K 3
the true asset and volatility dynamics, under the assumption of 1 2
V ( K ) ln K1 ln K 2
no jumps.) K K
x3 ( K ) =
V ( K 3 ) ln KK3 ln KK 3
n Remark 1. The validity of the previous replication argument 1 2
may be questioned because no stochastic-volatility model can In particular, if K = Kj then xi(K) = 1 for i = j and zero
produce implied volatilities that are flat and stochastic at the same otherwise.
time. The simultaneous presence of these features – though
inconsistent from a theoretical point of view – can, however, be The VV option price
justified on empirical grounds. In fact, the practical advantages of We can now proceed to the definition of an option price that is
the BS paradigm are so clear that many foreign-exchange option consistent with the market prices of the basic options.
traders run their books by revaluing and hedging according to a The above replication argument shows that a portfolio
BS flat-smile model, with the ATM volatility being continuously
e coefficient of (dSt)2 will be zeroed accordingly, due to the relation linking an option’s gamma and
updated to the actual market level.7 Th
5
8
This explains the name assigned to the smile-construction procedure, given the meaning of the terms
in the following section. vanna and volga.
Implied volatility
0.110 0.110
0.105 0.105
0.100 0.100
Data source: Bloomberg
0.095 0.095
0.090 0.090
1.05 1.10 1.15 1.20 1.25 1.30 1.35 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Strike Put delta
comprising xi(K) units of the option with strike Ki (and D0 units strike K2 , (7) can be simplified to:
of the underlying asset) gives a local perfect hedge in a BS world.
The hedging strategy, however, has to be implemented at C ( K ) = C BS ( K ) + x1 ( K ) C MKT ( K1 ) − C BS ( K1 )
prevailing market prices, which generates an extra cost with + x3 ( K ) C MKT ( K 3 ) − C BS ( K 3 )
respect to the BS value of the options portfolio. Such a cost has to
be added to the BS price (1), with t = 0, to produce an arbitrage-
free price that is consistent with the quoted option prices CMKT (K1), n Remark 2. Expressing the system (4) in the form b = Ax and
CMKT (K2) and CMKT (K3). setting c = (c1, c2, c3)′, where ci := CMKT (Ki) – CBS (Ki), and y = (y1,
In fact, in case of a short maturity – that is, for a small T – (3) y2, y3)′ := (A′) –1c, we can also write:
can be approximated as:
∂C BS
C ( K ) = C BS ( K ) + y1 (K )
( ST − K ) − C BS ( K ) − ∆ 0 [ ST − S0 ]
+
∂s
3 ∂2 C BS ∂2 C BS
− ∑ xi ( ST − K i ) − C BS ( K i )
+ + y2 ( K ) + y 3 (K )
∂s 2 ∂s∂S0
i=1
3
The difference between the VV and BS prices can thus be
≈ r d C BS ( K ) − ∆ 0 S0 − ∑ xi C BS ( K i ) T interpreted as the sum of the option’s vega, ∂Vega/∂Vol and
i=1 ∂Vega/∂Spot, weighted by their respective hedging cost y.9 Besides
so that setting: being quite intuitive, this representation also has the advantage
3 that the weights y are independent of the strike K and, as such,
C ( K ) = C BS ( K ) + ∑ xi ( K ) C MKT ( K i ) − C BS ( K i ) (7) can be calculated once for all. However, we prefer to stick to the
i =1 definition (7), since it allows an easier derivation of our
we have: approximations below.
The VV option price has several interesting features that we
( ST − K ) ≈ C ( K ) + ∆ 0 [ ST − S0 ]
+
analyse in the following.
3
When K = Kj, C(Kj) = CMKT (Kj), since xi(K) = 1 for i = j and
+ ∑ xi ( ST − K i ) − C MKT ( K i )
+
zero otherwise. Therefore, (7) defines a rule for either interpolating
i=1
or extrapolating prices from the three option quotes CMKT (K1),
3
CMKT (K2) and CMKT (K3).
+ r d C ( K ) − ∆ 0 S0 − ∑ xi C MKT ( K i ) T The option price C(K), as a function of the strike K, is twice
i=1 differentiable and satisfies the following (no-arbitrage) conditions:
Therefore, when actual market prices are considered, the option f
payout (ST – K)+ can still be replicated by buying D0 units of the lim K →0+ C ( K ) = S0 e− r T
and lim K →+∞ C ( K ) = 0
underlying asset and xi options with strike Ki (investing the d
resulting cash at rate rd), provided one starts from the initial lim K →0+ dC
dK ( K ) = − e− r T and lim K →+∞ K dK ( )
dC K = 0
endowment C(K).
The quantity C(K) in (7) is thus defined as the VV option’s These properties, which are trivially satisfied by CBS (K), follow
premium, implicitly assuming that the replication error is also from the fact that, for each i, both xi(K) and dxi(K)/dK go to zero
negligible for longer maturities. Such a premium equals the BS for K → 0+ or K → +∞.
price CBS (K) plus the cost difference of the hedging portfolio To avoid arbitrage opportunities, the option price C(K) should
induced by the market-implied volatilities with respect to the
constant volatility s. Since we set s = s2 , the market volatility for 9
The authors thank one of the referees for suggesting this alternative formulation.
www.risksouthafrica.com 41
cutting edge.option pricing
also be a convex function of the strike K, that is, (d2 C)/(dK2)(K) >
0 for each K > 0. This property, which is not true in general,10
A. Discount factors: July 1, 2005
Expiry Dollar Euro
holds for typical market parameters, so that (7) leads to prices
that are arbitrage-free in practice. 3M: October 3, 2005 0.9902752 0.9945049
%FSJWBUJWFT .BSLFUMFBEFST
SFBE3JTL
"UJDLJOH %PZPV
UJNFCPNC
SJTLOFU
Implied volatility
0.120 0.120
0.115 0.115
0.110 0.110
0.105 0.105
0.100 0.100
Data source: Bloomberg
0.095 0.095
0.090 0.090
1.05 1.10 1.15 1.20 1.25 1.30 1.35 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Strike Put delta
d f +∞
Two consistency results for the VV price V = e− r T h ( 0 ) + S0 e− r T h ′ ( 0 ) + ∫0 h ′′ ( K ) C ( K ) dK
We now state two important consistency results that hold
for the option price (7) and that give further support to the The same reasoning adopted above (see ‘The VV method: the
VV procedure. replicating portfolio’) with regard to the local hedge of the call
The first result is as follows. One may wonder what happens if with strike K can also be applied to the general payout h(ST). We
we apply the VV curve construction method when starting from can thus construct a portfolio of European-style calls with
three other strikes whose associated prices coincide with those maturity T and strikes K1, K2 and K3, such that the portfolio has
coming from (7). Clearly, for the procedure to be robust, we the same vega, ∂Vega/∂Vol and ∂Vega/∂Spot as the given
would want the two curves to exactly coincide. This is indeed derivative. Denoting by VBS the claim price under the BS model,
the case. this is achieved by finding the corresponding portfolio weights xh1,
In fact, consider a new set of strikes H := {H1, H2, H3}, for xh2 and xh3, which are always unique (see Proposition 1). We can
which we set: then define a new (smile-consistent) price for our derivative as:
3
CH ( Hi ) = CK ( Hi ) V = V BS + ∑ xih C MKT ( K i ) − C BS ( K i ) (10)
3 i =1
(8)
( ) ( )
= C BS ( H i ) + ∑ x j ( H i ) C MKT K j − C BS K j
j =1
which is the obvious generalisation of (7). Our second consistency
result is stated in the following.
where the superscripts H and K highlight the set of strikes the
pricing procedure is based on, and weights xj are obtained from K n Proposition 3. The claim price that is consistent with the
with (6). For a generic strike K, denoting by xi(K; H) the weights option prices (7) is equal to the claim price that is obtained by
for K that are derived starting from the set H, the option price adjusting its BS price by the cost difference of the hedging
associated to H is defined, analogously to (7), by: portfolio when using market prices CMKT (Ki) instead of the
3 constant-volatility prices CBS (Ki). In formulas:
( )
C H ( K ) = C BS ( K ) + ∑ x j ( K ; H ) C H H j − C BS H j
j =1
( ) V =V
Therefore, if we calculate the hedging portfolio for the claim
where the second term in the sum is now not necessarily zero under flat volatility and add to the BS claim price the cost
since H2 is, in general, different from K2 . The following proposition _
difference of the hedging portfolio (market price minus constant-
states the desired consistency result. volatility price), obtaining V , we exactly retrieve the claim price V
as obtained through the risk-neutral density implied by the call
n Proposition 2. The call prices based on H coincide with those option prices that are consistent with the market smile.13
based on K, namely, for each strike K: As an example of a possible application of this result, Castagna
& Mercurio (2005) consider the specific case of a quanto option,
CH (K ) = CK (K ) (9)
showing that its pricing can be achieved by using the three basic
A second consistency result that can be proven for the option options only, and not the virtually infinite range that is necessary
price (7) concerns the pricing of European-style derivatives and when using static replication arguments.
their static replication. To this end, assume that h(x) is a real
function that is defined for x ∈ [0, ∞), is well behaved at infinity An approximation for implied volatilities
and is twice differentiable. Given the simple claim with payout The specific expression of the VV option price, combined with
h(ST) at time T, we denote by V its price at time zero, when taking the analytical formula (6) for the weights, allows for the derivation
into account the whole smile of the underlying at time T. By Carr 13
ifferent but equivalent expressions for such a density can be found in Castagna & Mercurio (2005)
D
& Madan (1998), we have: and Beneder & Baker (2005).
www.risksouthafrica.com 43
cutting edge. option pricing
As we can see from figure 2, the approximation (12) is also Antonio Castagna is an equity derivatives trader at Banca Profilo, Milan. Fabio
extremely accurate in the wings, even for extreme values of put Mercurio is head of financial modelling at Banca IMI, Milan. They would like to
deltas. Its only drawback is that it may not be defined, due to the thank Giulio Sartorelli and three anonymous referees for their comments and
presence of a square-root term. The radicand, however, is positive helpful suggestions. Email: antonio.castagna@bancaprofilo.it
in most practical applications. fabio.mercurio@bancaimi.it
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