The volatility smile

Alternatives to Black-Scholes

Derivatives and Risk Management

Lecture 12: Volatility smiles and alternatives to Black-Scholes

Søren Hesel

Department of Business and Management

Fall 2022

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 The volatility smile
Alternatives to Black-Scholes

Outline

1 The volatility smile

2 Alternatives to Black-Scholes

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Implied volatilities
• The implied volatility for a given option is defined as the solution
σ∗ = σ∗ (S, t, K, T) to

fBS (S, t; K, T, σ∗ ) = fM

where fBS is the Black-Scholes price and fM is the market price

• If Black-Scholes holds: σ∗ (S, t, K, T) is constant!
• Empirical findings show that this is not the case
▶ For given t and St , σ∗ varies with K and T
▶ K 7→ σ∗ (for given T): the volatility smile
▶ T 7→ σ∗ (for given K): the volatility term structure
▶ (K, T) 7→ σ∗ : the volatility surface
• NOTE: implied volatility for a European put is identical to the
implied volatility of the equivalent European call (same
underlying, K, and T)
▶ No-arbitrage relation pt + St e−q(T−t) = ct + Ke−r(T−t) holds both for
market prices and Black-Scholes prices
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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Example
(Tutorial: Hull’s Question 19.4)

A European call and put option have the same strike price and time to
maturity. The call has an implied volatility of 30% and the put has an
implied volatility of 25%. What trades could your do?

Hints:
• Use that Black-Scholes option prices, cBS (St , t; σ, K), are
increasing in volatility so that

cM BS BS
t = c (St , t; 0.30, K) > c (St , t; 0.25, K)

• Then recall that the put-call parity holds in the BS model

cBS (St , t; σ, K) = pBS (St , t; σ, K) + St e−q(T−t) − Ke−r(T−t)

• Use this to conclude that the put-call parity is violated for the
market prices
−q(T−t)
cM M
t > pt + St e − Ke−r(T−t)

and exploit the arbitrage opportunity

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Example
(Tutorial: Hull’s Question 19.6)

The market price of a European call is $3.00 and its price given by the
Black-Scholes model with a volatility of 30% is $3.50. The price given
by this Black-Scholes model for a European put option with the same
strike price and time to maturity is $1.00. What should the market
price of the put option be? Explain the reasons for your answer.

Hints:
• Use that the put-call parity should hold for both the
Black-Scholes model and the market prices of the options:

ct − pt = St e−q(T−t) − e−r(T−t) K

• How does the right-hand side differ in the market and the
Black-Scholes model? See also Equation (19.2).

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Empirical smiles and term structures

FX options

Options on foreign exchange: symmetric volatility smile

• “peaked” and heavy-tailed implied risk-neutral distribution
▶ due to jumps
▶ due to stochastic volatility

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Empirical distribution
Fx Options

• Fx Options higher
”spike”
• Fatter tails
• Almost symmetric

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Empirical smiles and term structures

Equity options

• Equity options: implied vol decreases with K; volatility skew

▶ implied risk-neutral distribution has heavier left tail, less heavy right
tail
∗ due to leverage: St ↓ ⇒ leverage ↑ ⇒ equity more risky
∗ due to “crashophobia” ∼ fear of a stock market crash ⇒ price for
low-strike puts ↑
• Volatility smiles typically flatter for longer-term options

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Equity Options
Empirical smile and disctribution

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 The volatility smile Implied volatilities
Alternatives to Black-Scholes Empirical smiles and term structures

Reevaluating Black-Scholes

• Non-constant implied volatilities demonstrate that Black-Scholes

assumptions are not valid
▶ Traders use the Black-Scholes model with option-specific
volatilities. The model is used as an “interpolation tool”
▶ Hopefully, the prices computed with this approach are close to the
prices obtained in more realistic models
▶ More realistic models are needed to price options that are very
different from the options already traded and priced by the market

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The Constant Elasticity of Variance (CEV) model

Model setup, risk-neutral dynamics
dSt = (r − q)St dt + σStα dzQ
t

where α, r, q, and σ are positive constants. Equivalently:

dSt
= (r − q) dt + σStα−1 dzQ
St | {z } t
volatility

For α = 1: The model is identical to the Black-Scholes model

For α < 1:
• Volatility decreases in the stock price ⇝ (decreasing) volatility
skew observed for stock options
• Possible explanation: leverage effect
For α > 1:
• Volatility increases in the stock price ⇝ (increasing) volatility
skew sometimes observed for futures options
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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The CEV model, cont’d

Options are priced by solving the corresponding PDE


∂f ∂f 1 2 2α ∂2 f
∂t (S, t) + (r − q)S ∂S (S, t) + 2 σ S ∂S2 (S, t) − rf (S, t) = 0
f (S, T) = F(S)

OR by computing the discounted risk-neutral expectation of the payoff

f (St , t) = e−r(T−t) EQ [F(ST )] .

It can be shown that ST is non-centrally χ2 -distributed!

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The CEV model, cont’d

For the CEV model with α < 1:

c = S0 e−qT 1 − χ2 (a; b + 2, c) − Ke−rT χ2 (c; b, a),

 

p = Ke−rT 1 − χ2 (c; b, a) − S0 e−qT χ2 (a; b + 2, c)

 

where
• χ2 (·; k1 , k2 ) is the cumulative distribution function of a random
variable which is non-centrally χ2 -distributed with k1 degrees of
freedom and non-centrality parameter k2
• a, b, and c are given in terms of S, K, r, q, T, σ, and α

Only slightly more complicated than Black-Scholes!

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Merton’s jump-diffusion model

Recall that the GBM can be written

dSt = Sµdt + Sσdxt

where xt is a martingale; i.e. standard brownian motion.

• x is a pure continuous process
• The idea is to replace x with a process that is mostly continuous
but also includes jumps.
• So use xt = zt + mt where

dmt = −λk̄dt + k̃Nt dNt

λk̄ is the expected jump

k̃Nt dNt the jump at Nt

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The jumps process

Nt Poisson process with risk-neutral intensity λ

• Nt counts the number of jumps up to time t,
Nt ∈ {0, 1, 2, . . .}
• dNt = 1 if there is a jump at time t, otherwise
dNt = 0
λ intensity; i.e., the average number of jumps per year
k̃1 , k̃2 , · · · > −1 (limited liability) a sequence of i.i.d. jump sizes with
mean EQ [k̃n ] = k̄
in case of a jump at time t of size k̃Nt = k, the stock price changes by
kSt−

St− → St− + kSt− = St− (1 + k)

k < 0 captures a crash

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Geometric Jump diffusion

Risk-neutral dynamics of the stock price is assumed to be

dSt = r − q − λk̄ St dt + σSt dzQ
t + St− k̃Nt dNt

Recall the issue:

• BS model undervalues deep out-of-the-money options
• BS model overvalues near-the-money options
• Creates a U-shaped volatility smile (as observed for FX options)

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Merton’s jump-diffusion model, cont’d

Option pricing in the jump-diffusion model:

• Merton assumes a zero market price of jump risk
• If log(1 + k̃n ) is normally distributed with variance s2 , European
option price becomes
∞
X ′
e−λ T (λ ′ T)n
f = fn ,
n!
n=0

where λ ′ =p λ(1 + k̄) and fn is the BS-price computed with a

volatility of σ2 + ns2 /T instead of σ and an interest rate of
r − λk̄ + n log(1 + k̄)/T instead of r
• Heavier tails ⇝ currency options

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The variance-gamma model

Recall the GMB:
St = S0 e(µ− 2 σ )t+Xt
1 2

where X is a brownian motion with volatility σ. Recall that we discount

also with 21 σ2 such that S is a martingale under Q.
The idea is replace t in Xt with a random time γt . I.e. instead we use
(θ,σ)
Xt = Xγvt = θγvt + σWγvt

where W is a standard brownian motion, and γv is a gamma process

with rate v.
• v: Variance rate of the gamma process
• σ: The volatility of the stock
• θ: Defines the skewness of the distribution
▶ θ = 0: log St is symmetric
▶ θ < 0: log St is negatively skewed
▶ θ > 0: log St is positively skewed
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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The gamma process

• Define a variable g as the change over time T in a variable that

follows a gamma process with mean rate of 1 and variance rate
of v
▶ A gamma process is a pure jump process where small jumps occur
very frequently and large jumps occur only occasionally
• The probability density for g is

gT/v−1 e−g/v
vT/v Γ (T/v)

where Γ (·) denotes the gamma function

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The variance-gamma model, cont’d

Note I define ω = log 1 − θv − σ2 /2 /v and we write

ST = S0 e(r−q+ω)T+XT

• In a risk-neutral world log ST conditional on g is normal

▶ The conditional mean:

log S0 + (r − q + ω)T + θg

▶ The conditional standard deviation: σ√g

Søren Hesel DRM

 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The variance-gamma model, cont’d

• The variance-gamma model produces a U-shaped volatility

smile, not necessarily symmetrical
• The smile is very pronounced for short maturities and vanishes
for long maturities
• The model can be fitted to either equity or foreign currency plain
vanilla option prices

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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

The variance-gamma model, cont’d

Monte-Carlo simulation of option prices:
(1)
1 Draw M i.i.d. samples, u , . . . , u(M) , from U(0, 1).
2 Transform these into gamma distributed variates:
 
(m) T
g(m)
= FΓ−1
u ; ,v , m ∈ {1, . . . , M}
v
where FΓ (x; α, β) is the CDF of a gamma distributed random
variable with shape parameter α and scale parameter β.
3 Draw M i.i.d. samples, û(1) , . . . , û(M) , from U(0, 1).
4 Transform these into standard normally distributed variates:
 
ε(m) = Φ−1 û(m) , m ∈ {1, . . . , M}
where Φ denotes the CDF of the standard normal distribution.
5 The simulated values of the stock price is then
 q 
(m) (m) (m) (m)
ST = S0 exp (r − q + ω)T + θg + σ g ε
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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Hull & White stochastic volatility model

Recall GBM under Q:
dSt = St rdt + Sσdzt
I.e. volatility is constant! The idea is to replace σ2 with a stochastic
process Vt .
Model setup:
p
dSt = rSt dt + Vt St dzQ 1t
p
dVt = (µ(Vt ) − λ(Vt )) dt + ρξ(Vt )dzQ
1t + 1 − ρ2 ξ(Vt )dzQ
2t

where
• λ(V) is the risk premium of the variance
▶ Hull & White assume that λ(V) = 0
▶ empirically, volatility risk premium seems to be negative
• ξ is the volatility of the variance
• ρ denotes the correlation between S and V
▶ ρ < 0 is empirically reasonable for stock options
Søren Hesel DRM
 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Hull & White stochastic volatility model, cont’d

Option prices can be computed as follows:
• solve PDE

∂f 1 ∂2 f 1 ∂2 f √ ∂2 f
+ VS2 2 + ξ(V)2 2 + ρS Vξ(V)
∂t 2 ∂S 2 ∂V ∂S∂V
∂f ∂f
+ rS + (µ(V) − λ(V)) = rf
∂S ∂V
with terminal condition f (S, V, T) = F(S)
• Monte Carlo simulation based on

ft = e−r(T−t) EQ
t [F(ST )]

Note: need to simulate paths of (S, V)

R
• if ρ = 0: ft = 0∞ ftBS (V̄)g(V̄) dV̄, where V̄ is the average variance
and g(·) the probability density function of V̄
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 The Constant Elasticity of Variance model
The volatility smile Merton’s jump-diffusion model
Alternatives to Black-Scholes The variance-gamma model
Stochastic volatility model

Hull & White stochastic volatility model, cont’d

Results • Depending on parameter values—in particular the

correlation—the model can generate various types
of volatility smiles
• Stochastic volatility which has negative correlation
with the stock price may explain observed prices
and “volatility skew” of stock options
• In general, price differences relative to
Black-Scholes seem small, at least for short-term,
near-the-money options
Remarks • Stochastic volatility has a larger impact on the
efficiency of Black-Scholes hedging strategy (the
Greeks)
• Negative correlation between S and V (or σ) can be
explained by leverage effect

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