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(Merrill Lynch, Youssfi) Convexity Adjustment For Volatility Swaps
(Merrill Lynch, Youssfi) Convexity Adjustment For Volatility Swaps
volatility swaps
Chrif YOUSSFI
Global Equity Linked Products
Outline
70.00%
60.00%
stochastic volatility
Volatility
50.00%
40.00% Implied
model where:spot
30.00%
20.00% is 100,maturity 1y
10.00%
0.00%
and correlation is
0 50 100 150 200
Strik es
250 300 350
estimated at -70%
• What is the price of ATM option?
By considering the linearity of the option price w.r.t.
volatility, the price is approximately 14.11%
• What is the value of the variance swap? 16.17%.
• What is the value of the volatility Swap? More difficult.
Intuition
t
t dt
1 2
( S ,
with the initial condition 0 0 and) dWt , dW
2 t 0
1 1
B ( z , 0 , v, ) 0 | z | (1 2 02 z 2 ) KS 0 O( 4 )
4 24
1
h { 02 v 2 (2 3 2 ) 6 v 0 } X 2
24
• In the BS case we have a similar formula with v 0 :
1 2 2
BS (T , K ) 0 1 vz 6 v 0 v (2 3 ) 2v z (2 3 ) O( 4 )
2 2 2 2
2 24
Volatility swap convexity adjustment
4 2
• The smile convexity of the implied volatility is:
1 3
implied 0 v 2 2 O( 4 )
8
Convexity adjustment
• As long as the 2 is large enough (which is satisfied in the
equity markets), to the leading orders show that the
relation between the two convexities is very simple:
4
Var / Vol O ( 4
)
3 2 implied
4.50%
4.00%
3.50%
3.00%
Adjustment
2.50% MC
2.00% Formula
Vol=40%
1.50% Rho=-90%
1.00% T=1 yr
Epsilon=1
0.50%
0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80%
voVol
Numerical Results (5)
Convexity adjustment vs Smile Convexity
3.50%
3.00%
2.50%
Adjustment
2.00% MC
1.50% Formula
Vol=30%
1.00% Rho=-90%
T=1 yr
0.50% Epsilon=1
0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80%
voVol
Numerical Results(6): Heston
Convexity adjustment vs Smile Convexity
3.00%
2.50%
Vol=40%
2.00% Rho=-70%
T=1 yr
1.50% Lambda=80%
Vbar=16%
1.00%
MC
0.50% Theory
0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80%
Numerical Results (7): Heston
Convexity adjustment vs Smile Convexity
3.00%
2.50%
Vol=40%
2.00% Rho=-90%
T=1 yr
1.50% Lambda=80%
Vbar=16%
1.00% MC
Theory
0.50%
0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80%
Conclusion