Modelling Volatility Skews

Bruno Dupire
Bloomberg
bdupire@bloomberg.net

London, November 17, 2006

 OUTLINE

1.Generalities
2.Leverage and jumps
3.Break-even volatilities
4.Volatility models
5.Forward Skew
6.Smile arbitrage
I. Generalities
 Market Skews

Dominating fact since 1987 crash: strong negative skew on

Equity Markets

K
Not a general phenomenon

Gold: FX:

K K

We focus on Equity Markets

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 Skews

• Volatility Skew: slope of implied volatility as a

function of Strike
• Link with Skewness (asymmetry) of the Risk
Neutral density function ?

Moments Statistics Finance

1 Expectation FWD price
2 Variance Level of implied vol
3 Skewness Slope of implied vol
4 Kurtosis Convexity of implied vol

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 Why Volatility Skews?
• Market prices governed by
– a) Anticipated dynamics (future behavior of volatility or jumps)
– b) Supply and Demand
Sup Market Skew
ply a
nd D
ema
nd
Th. Skew
K
• To “ arbitrage” European options, estimate a) to capture
risk premium b)
• To “arbitrage” (or correctly price) exotics, find Risk
Neutral dynamics calibrated to the market

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 Modeling Uncertainty
Main ingredients for spot modeling
• Many small shocks: Brownian Motion
(continuous prices) S

• A few big shocks: Poisson process (jumps)

S

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 2 mechanisms to produce Skews (1)

• To obtain downward sloping implied volatilities

– a) Negative link between prices and volatility

• Deterministic dependency (Local Volatility Model)
• Or negative correlation (Stochastic volatility Model)

– b) Downward jumps

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 2 mechanisms to produce Skews (2)
– a) Negative link between prices and volatility

– b) Downward jumps

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Leverage and Jumps
 Dissociating Jump & Leverage effects
t0 t1 t2

x = St1-St0 y = St2-St1

• Variance :
Option prices FWD variance
Δ Hedge

• Skewness :

Option prices Leverage

Δ Hedge
FWD skewness

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 Dissociating Jump & Leverage effects

Define a time window to calculate effects from jumps and

Leverage. For example, take close prices for 3 months

• Jump:

• Leverage:

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 Dissociating Jump & Leverage effects

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 Dissociating Jump & Leverage effects

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Break Even Volatilities
 Theoretical Skew from Prices

?
=>
Problem : How to compute option prices on an underlying without
options?
For instance : compute 3 month 5% OTM Call from price history only.
1) Discounted average of the historical Intrinsic Values.
Bad : depends on bull/bear, no call/put parity.
2) Generate paths by sampling 1 day return recentered histogram.
Problem : CLT => converges quickly to same volatility for all
strike/maturity; breaks autocorrelation and vol/spot dependency.

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 Theoretical Skew from Prices (2)

3) Discounted average of the Intrinsic Value from recentered 3 month

histogram.
4) Δ-Hedging : compute the implied volatility which makes the
Δ-hedging a fair game.

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 Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history? S
Example: K

3 month daily data

t
1 strike
– a) price and delta hedge for a given within Black-Scholes
model
– b) compute the associated final Profit & Loss:
– c) solve for
– d) repeat a) b) c) for general time period and average
– e) repeat a) b) c) and d) to get the “theoretical Skew”

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 Strike dependency
• BE volatility is an average of returns,
weighted by the Gammas, which depend
on the strike

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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Local Volatility Model
 One Single Model
• We know that a model with dS = σ(S,t)dW
would generate smiles.
– Can we find σ(S,t) which fits market smiles?
– Are there several solutions?

ANSWER: One and only one way to do it.

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 The Risk-Neutral Solution
But if drift imposed (by risk-neutrality), uniqueness of the solution

Risk
Diffusions Neutral
Processes

Compatible
with Smile

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 Forward Equation

• BWD Equation: price of one option for different

• FWD Equation: price of all options for current

• Advantage of FWD equation:

– If local volatilities known, fast computation of implied volatility
surface,
– If current implied volatility surface known, extraction of local
volatilities:

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 Forward Equations (2)
• Several ways to obtain them:
– Fokker-Planck equation:
• Integrate twice Kolmogorov Forward Equation
– Tanaka formula:
• Expectation of local time
– Replication
• Replication portfolio gives a much more financial
insight

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 Volatility Expansion

•K,T fixed. C0 price with LVM

•Real dynamics:

•Ito

• Taking expectation:

•Equality for all (K,T) ⬄

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 Summary of LVM Properties
is the initial volatility surface

• compatible with local vol

• compatible with
(calibrated SVM are noisy versions of LVM)

• deterministic function of (S,t) (if no jumps)

future smile = FWD smile from local vol

• Extracts the notion of FWD vol (Conditional Instantaneous Forward

Variance)

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Stochastic Volatility Models
 Heston Model

Solved by Fourier transform:

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 Role of parameters
• Correlation gives the short term skew
• Mean reversion level determines the long term
value of volatility
• Mean reversion strength
– Determine the term structure of volatility
– Dampens the skew for longer maturities
• Volvol gives convexity to implied vol
• Functional dependency on S has a similar effect
to correlation

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 Spot dependency

2 ways to generate skew in a stochastic vol model

σ σ

ST ST

-Mostly equivalent: similar (St,σt ) patterns, similar future

evolutions
-1) more flexible (and arbitrary!) than 2)
-For short horizons: stoch vol model ⬄ local vol model +
independent noise on vol.

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 SABR model

• F: Forward price

with correlation ρ

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 The SABR Claim

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 Market behavior

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 SABR fallacy

• SABR claims to dissociate vol dynamics from

Skew fitting

• Many banks manage their vol risk with SABR

• BUT if 2 SABR models fit the same skew, they

generate essentially the same vol dynamics,
which coincide in average with LVM dynamics!

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 Calibration according to SABR

Backbone: as a function of F with frozen

depends only on

Many banks calibrate by:

1) Estimating from historical backbone

2) Then adjusting to fit the skew

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 Problems

• Freezing ignores which actually impacts the average backbone

• SABR can be rewritten with the lognormal volatility

• In this parameterization instead of , freezing

gives : the backbone is then constant!

The backbone depends on the parameterization , it is not intrinsic to

the model: it is a flawed concept

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 Message from LVM

In particular for short maturities

so average backbone ~ local vols!

In the absence of jumps, the skew is due to average levels

of vols higher on the downside

If you were in that region

increases

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 2 fitting models

• SABR A

A 0.1 0 0.1 0
• SABR B B 0.1 1 0.175 -0.58
calibrated to A

Same skew Different backbones

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 Comparison

Scattered plot Average backbone

in average
Same skew similar vol dynamics = LVM vol dynamics

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 SABR Conclusion

• To dissociate vol dynamics from skew fitting, jumps are

needed

• In a smile (as opposed to skew) dominated market, it is

less clear as and cancel their first order impact

• Banks may be unaware of the inconsistency of their risk

management

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Forward Skew
 Forward Skews

In the absence of jump :

model fits market
This constrains
a) the sensitivity of the ATM short term volatility wrt S;
b) the average level of the volatility conditioned to ST=K.

a) tells that the sensitivity and the hedge ratio of vanillas depend on the
calibration to the vanilla, not on local volatility/ stochastic volatility.
To change them, jumps are needed.
But b) does not say anything on the conditional forward skews.

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 Controlling Fwd Skew

Many products depend on short term skew in the future

Example: Napoleon, globally/locally capped/floored cliquet

Local cap/floor:

Global cap/floor:

What does current vol surface tell us on future short term skew?

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 Toy model
A) : freeze vol at beginning of month

flat 1 month skew but if decreases: generate initial skew

but flat future skew

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 Toy model

B) (or slightly increasing in )

but not flat future skew

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 Limitations

• Behavior of future 1 month skew very different if start

date is mid month instead of beginning of month

• The amplitude of jumps is a measure of the wrongness of

the model

• LVM corresponds to the jumpless case

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 Sensitivity of ATM volatility / S

At t, short term ATM implied volatility ~ σt.

As σt is random, the sensitivity is defined only in average:

In average, follows .
Optimal hedge of vanilla under calibrated stochastic volatility corresponds to
perfect hedge ratio under LVM.

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 Market Model of Implied Volatility
• Implied volatilities are directly observable
• Can we model directly their dynamics?

where is the implied volatility of a given

• Condition on dynamics?

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 Drift Condition

• Apply Ito’s lemma to

• Cancel the drift term
• Rewrite derivatives of
gives the condition that the drift of must satisfy.
For short T, we get the Short Skew Condition (SSC):

close to the money:

🡺 Skew determines u1

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 H
Optimal hedge ratio Δ

• : BS Price at t of Call option with

strike K, maturity T, implied vol
• Ito:
• Optimal hedge minimizes P&L variance:

Implied Vol
BS Vega sensitivity
BS Delta

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 H
Optimal hedge ratio Δ II

With

🡺 Skew determines u1, which determines ΔH

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Smile Arbitrage
 Deterministic future smiles
It is not possible to prescribe just any future
smile
If deterministic, one must have

Not satisfied in general

K
S0

t0 T1 T2

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 Det. Fut. smiles & no jumps
=> = FWD smile
If

stripped from Smile S.t

Then, there exists a 2 step arbitrage:

K
Define S0
S
At t0 : Sell
t0 t T
At t:

gives a premium = PLt at t, no loss at T

Conclusion: independent of
from initial smile

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 Consequence of det. future smiles

• Sticky Strike assumption: Each (K,T) has a fixed

independent of (S,t)
• Sticky Delta assumption: depends only on moneyness
and residual maturity

• In the absence of jumps,

– Sticky Strike is arbitrageable
– Sticky Δ is (even more) arbitrageable

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 Example of arbitrage with Sticky Strike
Each CK,T lives in its Black-Scholes ( )world

P&L of Delta hedge position over dt:

! If no jump

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 Arbitrage with Sticky Delta

• In the absence of jumps, Sticky-K is arbitrageable and Sticky-Δ even more so.
• However, it seems that quiet trending market (no jumps!) are Sticky-Δ.
In trending markets, buy Calls, sell Puts and Δ-hedge.

Example:

S PF
Δ-hedged PF gains
Vega > Vega
from S induced
volatility moves.
S PF
Vega < Vega

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 Conclusion
• Both leverage and asymmetric jumps may generate skew
but they generate different dynamics

• The Break Even Vols are a good guideline to identify risk

premia

• The market skew contains a wealth of information and in

the absence of jumps,
– The spot correlated component of volatility
– The average behavior of the ATM implied when the spot moves
– The optimal hedge ratio of short dated vanilla
– The price of options on RV

• If market vol dynamics differ from what current skew

implies, statistical arbitrage

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