Skew Modeling

Bruno Dupire
Bloomberg LP
bdupire@bloomberg.net
Columbia University, New York
September 12, 2005

I.

Generalities

Market Skews
Dominating fact since 1987 crash: strong negative skew on
Equity Markets
impl
K

Not a general phenomenon

Gold: impl

FX: impl
K

We focus on Equity Markets

Bruno Dupire

Skews
Volatility Skew: slope of implied volatility as a
function of Strike
Link with Skewness (asymmetry) of the Risk
Neutral density function ?
Moments
1
2
3
4
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Statistics
Expectation
Variance
Skewness
Kurtosis

Finance
FWD price
Level of implied vol
Slope of implied vol
Convexity of implied vol
4

Why Volatility Skews?

Market prices governed by
a) Anticipated dynamics (future behavior of volatility or jumps)
b) Supply and Demand

impl

Sup
Market Skew
ply
and
Dem
and

Th. Skew

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
t

A few big shocks: Poisson process (jumps)

S

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2 mechanisms to produce Skews (1)

To obtain downward sloping implied volatilities
imp
K

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

S1

S2

b) Downward jumps

S1
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S2
8

Leverage and Jumps

Dissociating Jump & Leverage effects

t0

t1

t2

x = St1-St0

Variance :

y = St2-St1

(x + y) = x + 2xy+ y
2

Option prices

FWD variance
Hedge

Skewness :

(x + y)3 = x3 + 3x2 y + 3xy2 + y3

Leverage

Option prices
Hedge
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FWD skewness
10

Dissociating Jump & Leverage effects

Define a time window to calculate effects from jumps and
Leverage. For example, take close prices for 3 months

Jump:

(S )

ti

Leverage:

(S

ti

)( )

S t1 S ti

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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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15

Theoretical Skew from Prices (2)

3) Discounted average of the Intrinsic Value from recentered 3 month
histogram.
4) -Hedging : compute the implied volatility which makes the hedging a fair game.

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16

Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history?
S
K
Example:
ST
3 month daily data
t
T1
T2
1 strike K = k ST1
a) price and delta hedge for a given within Black-Scholes
1

model
b) compute the associated final Profit & Loss: PL( )
c) solve for k / PL k = 0
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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( )

( ( ))

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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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Barriers as FWD Skew trades

Beyond initial vol surface fitting

Need to have proper dynamics of implied volatility
Future skews determine the price of Barriers and
OTM Cliquets
Moves of the ATM implied vol determine the of
European options
Calibrating to the current vol surface do not impose
these dynamics

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23

Barrier Static Hedging

Down & Out Call Strike K, Barrier L, r=0 :
With BS: DOCK ,L = CK K L PL2
K

If S t = L ,unwind hedge, at 0
cost
If not touched, IVs are equal

2
L

K
L
K

L2

With normal model

DOCK , L = C K P2 L K
dS = dW
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2L-K
1

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Static Hedging: Model Dominance

Back to DOCK , L
L
K

An assumption as the skew at L corresponds to

an affine model
dS = (aS + b )dW (displaced LN)
DOCK ,L priced as in BS with shifted K and L gives
new hedging PF which is >0 when L is touched if
Skew assumption is conservative
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Skew Adjusted Barrier Hedges

dS = (aS + b )dW
DOC K , L

aK + b
CK
PaL2 +b (2 L K )
aL + b
aK + b

UOC K , L

aK + b
C aL2 +b (2 L K )
C K (L K ) 2 Dig L +
CL
aL + b aL + b

aK + b

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Local Volatility Model

One Single Model

We know that a model with dS = (S,t)dW
would generate smiles.
Can we find (S,t) which fits market smiles?
Are there several solutions?

ANSWER: One and only one way to do it.

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28

The Risk-Neutral Solution

But if drift imposed (by risk-neutrality), uniqueness of the solution

Risk
Neutral
Processes

Diffusions

Compatible
with Smile

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sought diffusion
(obtained by integrating twice
Fokker-Planck equation)

29

Forward Equations (1)

BWD Equation:
price of one option C (K 0 ,T0 ) for different (S, t )
FWD Equation:
price of all options C (K , T ) for current (S 0 ,t0 )
Advantage of FWD equation:
If local volatilities known, fast computation of implied
volatility surface,
If current implied volatility surface known, extraction of
local volatilities,
Understanding of forward volatilities and how to lock
them.
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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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Fokker-Planck
If dx = b( x, t )dW
1 2 (b 2 )
Fokker-Planck Equation:
=
t 2 x 2

2C
Where is the Risk Neutral density. As =
K 2
2 C

t =
x 2

2
2C
2 2 C

2
b
2
K = 1 K
t
x 2
2

Integrating twice w.r.t. x: C b2 2C

=
t 2 K 2
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Volatility Expansion
K,T fixed. C0 price with LVM 0 ( S t , t ) : dS t = 0 ( S t , t ) dWt
Real dynamics: dSt = t dWt
2

C0 2
1
+
2
0
dS +
(

Ito ( ST K ) = C0 ( S 0 ,0) +
0 ( S t , t )) dt
t
2
S
2 0 S
0
T

Taking expectation:
1
C ( S 0 ,0) = C0 ( S 0 ,0) + 0 ( S , t ) t2 St = S 02 ( S , t ) ( S , t )dSdt
2
2
2
Equality for all (K,T) t S t = S = 0 ( S , t )

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([

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Summary of LVM Properties

0 is the initial volatility surface
(S,t ) compatible with 0 =

( ) compatible with E[
0

k,T

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local vol

ST = K ] = (local vol)

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

future smile = FWD smile from local vol

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Stochastic Volatility Models

Heston Model
dS
S = dt + v dW

dv = v 2 v dt + v dZ

dW , dZ = dt

Solved by Fourier transform:

FWD
x ln
=T t
K
C K ,T ( x, v, ) = e x P1 ( x, v, ) P0 ( x, v, )

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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
1) t = xt f (S , t ), (W , Z ) = 0
2)

(W , Z ) 0

S0

ST

ST
S0

-Mostly equivalent: similar (St,t ) 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

dF = F t dW
d

= dZ

With correlation

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Smile Dynamics

Smile dynamics: Local Vol Model (1)

Consider, for one maturity, the smiles associated
to 3 initial spot values
Skew case

Local vols

Smile S
Smile S 0
Smile S +

S S0 S +

ATM short term implied follows the local vols

Similar skews
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51

Smile dynamics: Local Vol Model (2)

Pure Smile case
Local vols

Smile S +
Smile S

Smile S 0

S0

S+

ATM short term implied follows the local vols

Skew can change sign
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Smile dynamics: Stoch Vol Model (1)

Skew case (r<0)

Local vols

Smile S
Smile S 0
Smile S +

S+

S S0

- ATM short term implied still follows the local vols

(E [

S T = K = 2 (K , T )

- Similar skews as local vol model for short horizons

- Common mistake when computing the smile for another
spot: just change S0 forgetting the conditioning on :
if S : S0 S+ where is the new ?
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Smile dynamics: Stoch Vol Model (2)

Pure smile case (r=0)

Local vols

Smile S +

Smile S

Smile S 0

S0

S+

ATM short term implied follows the local vols

Future skews quite flat, different from local vol
model
Again, do not forget conditioning of vol by S
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Smile dynamics: Jump Model

Skew case
Local vols

Smile S
Smile S 0

Smile S +

S0 S +

ATM short term implied constant (does not follows the

local vols)
Constant skew
Sticky Delta model
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Smile dynamics: Jump Model

Pure smile case

Local vols

Smile S 0

Smile S +

Smile S

S0

S+

ATM short term implied constant (does not follows the

local vols)
Constant skew
Sticky Delta model
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Smile dynamics
Weighting scheme imposes
some dynamics of the smile for
a move of the spot:
For a given strike K,

S1
S0

S K
(we average lower volatilities)
Smile today (Spot St)
&
Smile tomorrow (Spot St+dt)
in sticky strike model

t
26

25.5
25

Smile tomorrow (Spot St+dt)

if ATM=constant

24.5

Smile tomorrow (Spot St+dt)

in the smile model

23.5

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St+dt

St
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Volatility Dynamics of different models

Local Volatility Model gives future short term
skews that are very flat and Call lesser than
Black-Scholes.
More realistic future Skews with:
Jumps
Stochastic volatility with correlation and meanreversion
To change the ATM vol sensitivity to Spot:
Stochastic volatility does not help much
Jumps are required
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ATM volatility behavior

Forward Skews
In the absence of jump :
model fits market

K , T

2
E[ T2 ST = K ] = loc
(K ,T )

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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60

Sensitivity of ATM volatility / S

At t, short term ATM implied volatility ~ t.
As t is random, the sensitivity

Et [

2
t +t

t
S

is defined only in average:

2
loc
(S , t )
St = St + S ] = ( St + S , t + t ) ( St , t )
S
S
2
t

2
loc

2
loc

2
2
In average, ATM
follows loc
.

Optimal hedge of vanilla under calibrated stochastic volatility corresponds to

perfect hedge ratio under LVM.

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61

Market Model of Implied Volatility

Implied volatilities are directly observable
Can we model directly their dynamics? (r = 0)
dS
S = dW1

d = dt + u dW + u dW
1
1
2
2

where is the implied volatility of a given C K ,T
Condition on dynamics?
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Drift Condition
C(S, , t )

Apply Itos lemma to

Cancel the drift term

Rewrite derivatives of

C(S, , t )

gives the condition that the drift

of d

must satisfy.

For short T, we get the Short Skew Condition (SSC):

2

K
K

2
= + u1 ln( ) + u2 ln( )
S
S

K
2
close to the money: ~ + u1 ln( )
S
Skew determines u1

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C ( S , , t)

t T

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Optimal hedge ratio H

C ( S , , t ) : BS Price at t of Call option with

strike K, maturity T, implied vol

Ito: dC ( S , , t ) = 0dt + CS dS + C d
Optimal hedge minimizes P&L variance:
dC.dS
d .dS
H
=
= CS + C
2
2
(dS )
(dS )
Implied Vol

BS Delta

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BS Vega

sensitivity

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Optimal hedge ratio H II

d .dS
= CS + C
(dS ) 2
H

dS
S = dW1
With
d = dt + u dW + u dW
1
1
2
2

d .dS u1S (dW1 ) 2 u1

=
=
2
2
2
S
(dS )
(S ) (dW1 )
Skew determines u1, which determines H
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Smile Arbitrage

Deterministic future smiles

It is not possible to prescribe just any future
smile
If deterministic, one must have
C K ,T (S 0 , t 0 ) = (S 0 , t 0 , S , T1 ) C K ,T (S , T1 )dS
2

Not satisfied in general

K
S0

t0

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T1

T2

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Det. Fut. smiles & no jumps

=> = FWD smile
2
2
If (S , t , K , T ) / VK ,T (S , t ) (K , T ) lim imp (K , T , K + K , T + T )

K 0
T 0

stripped from Smile S.t

Then, there exists a 2 step arbitrage:

Define
2C
2

( (K , T ) V (S , t )) K (S , t , K , T )

PL t

K ,T

At t0 : Sell PL t Dig S ,t Dig S + ,t

At t: if S [S , S + ]
t

S0

t0

2
buy
CS K, T , sell
2
K

t
2

(K , T ) K ,T

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

Conclusion: VK ,T (S , t ) independent of
from initial smile
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(S , t ) = VK ,T (S0 , t0 ) = 2 (K , T )
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Consequence of det. future smiles

Sticky Strike assumption: Each (K,T) has a fixed impl ( K , T )
independent of (S,t)
Sticky Delta assumption: impl ( K , T ) depends only on
moneyness and residual maturity

In the absence of jumps,

Sticky Strike is arbitrageable
Sticky is (even more) arbitrageable

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Example of arbitrage with Sticky Strike

Each CK,T lives in its Black-Scholes ( impl ( K , T ) )world

C1 C K 1 ,T1

assume 1 > 2

C 2 C K 2 ,T2

P&L of Delta hedge position over dt:

PL (C 1 ) =

1
2

PL (C 2 ) =

1
2

(( S ) S t )
(( S ) S t )
2

PL (1C 2 2 C 1 ) =

(no , free )

12 2 2
S 1 22 t > 0
2

!
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1C 2

2 C 1

S t1

S t + t

If no jump

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Arbitrage with Sticky Delta

In the absence of jumps, Sticky-K is arbitrageable and Sticky- even more so.
However, it seems that quiet trending market (no jumps!) are Sticky-.
In trending markets, buy Calls, sell Puts and -hedge.
Example:
K1

PF C K 2 PK1
S

K2

1 , 2
VegaK > Vega K
2

1 , 2
VegaK < Vega K
2

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St

PF
1

PF

-hedged PF gains
from S induced
volatility moves.

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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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