position, clearing, hedging, etc).

When a trader starts writing options on recently issued stocks, or wants

to write and trade exotic derivatives it can also use the implied volatilties
from companies in the same industry and currency area, or the same industry
but different currencies (in the latter case, it is necessary to convert the im-
plied volatility in a currency to the implied volatility on the other currency).
We will not enter into the discussion the joint risk of currency and equities
in this paper, we will see just how a few derivatives behave under a volatility
smile environment.

Given the universe of options in Table 1, let’s suppose a trader writes

the following new instruments:
A.
( A digital option with option lifetime T1 = 1 year and payoff f1 (ST ) =
1, ST > 100
0, ST < 100
B.
( A digital option with option lifetime T2 = 9 months and payoff f2 (ST ) =
1, ST > 100
0, ST < 100
C.
( A digital option with option lifetime T3 = 9 months and payoff f3 (ST ) =
1, ST > 97.5
.
0, ST < 97.5
D.
 A structured option with lifetime T4 = 9 months and payoff f4 (ST ) =
0, ST ≤ 90

1
2
(ST − 90), 90 < ST < 100 .

(ST − 100), ST ≥ 100


I will attempt to answer the following questions:

1. How would you price the products? Which are the risk factors?
2. In what ways could we replicate and hedge them ?
3. What are the sensitivities? Are these any different than under a flat smile
case?

In most of the cases, in order to answer we would need the implied volatil-
ities table and interpolate the results.
For our example, the corresponding table of implied volatilities is shown be-