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You are on page 1of 49

Jim Gatheral

Stanford Financial Mathematics Seminar

February 28, 2003

This presentation represents only the personal opinions of the author and

not those of Merrill Lynch, its subsidiaries or affiliates.

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The relationship between volatility and volume

Clustering

Correlation between volatility changes and log returns

Stochastic volatility

Dynamics of the volatility skew

Similarities between stochastic volatility models

Do stochastic volatility models fit option prices?

Jumps

The impact of large option trades

n

trading time such that the rate of arrival of stock trades in a given

(transformed) time interval is a constant .

Intuitively, relative to real time, trading time flows faster when there is

more activity in the stock and more slowly when there is less activity.

Suppose that the (random) size n of a trade is independent of the level of

activity in the stock.

Assume further that each trade impacts the mid-log-price of the stock by

an amount proportional to n .

N

x = sgn( ni ) ni

i =1

Note that both the number of trades N and the size of each trade ni in a

given time interval t are random.

n

= 2 t E [ ni ]

n

Var [ x ] = 2 t = 2 t E [ n i ]

n

interval t .

The factor t cancels and transforming back to real time, we see that

variance is directly proportional to volume in this simple model.

Moreover, the distribution of returns in trading time is approximately

Gaussian for large t .

The

n

relationship

proportional to the square root of the trade size n . The following

argument shows why this is plausible:

inventory.

Risk is proportional to T where T is the holding period.

The holding period should be proportional to the size of the position.

So the required excess return must be proportional to n .

IBM from 4/30/2001 to 2/24/2003

0.009

0.008

0.007

ln^2(hi/lo)

0.006

y = 1E-10x

R2 = 0.2613

0.005

0.004

0.003

0.002

0.001

0

0

10,000,000

20,000,000

30,000,000

Volume (Shares)

40,000,000

50,000,000

MER from 2/26/2001 to 2/24/2003

0.02

0.018

0.016

ln^2(hi/lo)

0.014

0.012

y = 3E-10x

R2 = 0.2895

0.01

0.008

0.006

0.004

0.002

0

0

5,000,000

10,000,000

15,000,000

Volume (Shares)

20,000,000

25,000,000

n

Our simple but realistic model has the following modeling implications

Log returns are roughly Gaussian with constant variance in trading time

(sometimes call intrinsic time) defined in terms of transaction volume

Trading time is the inverse of variance

When we transform from trading time to real time, variance appears to be

random

subordinated to another random process which is really trading volume

in our model - stochastic volatility

What form should the volatility process take?

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of volatility (the same argument that is used to justify the mean reversion

of interest rates):

Consider the distribution of the volatility of IBM in one hundred years time

say. If volatility were not mean-reverting ( i.e. if the distribution of volatility

were not stable), the probability of the volatility of IBM being between 1%

and 100% would be rather low. Since we believe that it is overwhelmingly

likely that the volatility of IBM would in fact lie in that range, we deduce

that volatility must be mean-reverting.

n

volatilities

The term structure of implied volatility has the form of exponential

decay to a long-term level

The shape and dynamics of the volatility term structure imply that

volatility must mean-revert i.e. that volatility changes are auto-correlated

The following slides show that this is also true empirically.

IBM Log Returns vs Volume

80000000

0.15

70000000

0.1

60000000

Volume

50000000

0

40000000

-0.05

30000000

-0.1

20000000

-0.15

10000000

01/03/2003

01/03/2002

01/03/2001

01/03/2000

01/03/1999

01/03/1998

01/03/1997

01/03/1996

01/03/1995

01/03/1994

01/03/1993

01/03/1992

01/03/1991

-0.2

01/03/1990

Log Returns

0.05

MER Log Returns vs Volume

30000000

0.2

25000000

0.15

Volume

0.05

15000000

0

10000000

-0.05

5000000

-0.1

01/03/2003

01/03/2002

01/03/2001

01/03/2000

01/03/1999

01/03/1998

01/03/1997

01/03/1996

01/03/1995

01/03/1994

01/03/1993

01/03/1992

01/03/1991

-0.15

01/03/1990

Log Returns

0.1

20000000

n

strike price indicates that volatility changes must be negatively

correlated with log returns.

Implied Volatility vs Strike

June 2002 options as of 4/24/2002

55.00%

50.00%

45.00%

40.00%

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

700

800

900

1,000

1,100

1,200

1,300

1,400

The following slide shows that volatility changes really are anticorrelated with stock price changes

Correlation of vol changes with log returns

15.00%

Volatility Change

10.00%

5.00%

-8.00%

-6.00%

-4.00%

0.00%

-2.00%

0.00%

-5.00%

-10.00%

-15.00%

Log Return

y = -1.1066x + 0.0003

R2 = 0.6218

2.00%

4.00%

6.00%

8.00%

n

model consistent with our observations. Let x denote the log stock price

and v denote its variance. Then

dx = dt + v dZ1

dv = ( v ) + v v dZ 2

with dZ1 , dZ 2 = dt .

n

moves and stock price moves and is called volatility of volatility.

= 0 gives the Heston model

= 12 gives Wiggins' lognormal model

n

n

n

So far, we have ascertained that the volatility process must be meanreverting and that volatility moves are anti-correlated with log returns.

Can we say anything about the diffusion coefficient?

The following four slides give a sense of the dynamics of the volatility

surface

We see that as volatility increases

and so does the volatility skew

VIX Index

60

50

40

30

20

10

0

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00

6.00%

5.00%

1.339

y = 0.0954x

4.00%

3.00%

2.00%

1.00%

0.00%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

8%

40%

7%

35%

Put Skew

Oct-01

Aug-01

Jun-01

May-01

Mar-01

Jan-01

Dec-00

Oct-00

Aug-00

Jul-00

May-00

Apr-00

Feb-00

Dec-99

Nov-99

0%

Sep-99

0%

Aug-99

5%

Jun-99

1%

Apr-99

10%

Mar-99

2%

Jan-99

15%

Nov-98

3%

Oct-98

20%

Aug-98

4%

Jun-98

25%

May-98

5%

Mar-98

30%

Jan-98

6%

Note that skew is defined to be the difference in volatility for 0.25 delta

Jim Gatheral, Merrill Lynch, February-2003

0.09

0.08

1.6316

y = 0.3774x

2

R = 0.5476

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0.00

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

3m ATM Volatility

Note that skew is defined to be the difference in volatility for 0.25 delta

Jim Gatheral, Merrill Lynch, February-2003

n

approximately the same shape

The Heston model dv = ( v v ) dt + v dZ has an implied

volatility term structure that looks to leading order like

(1 e T )

2

BS ( x, T ) v + ( v v )

T

Its easy to see that this shape should not depend very much on the

particular choice of model.

Also, Gatheral (2002) shows that the term structure of the volatility skew

has the following approximate behavior for all stochastic volatility

models of the generic form dv = ( v ) dt + ( v ) v dZ:

( v ) (1 e T )

2

BS ( x, T )

1

x

T

T

with = ( v ) / 2

n

v v v t Z

n

t Z

2

All four graphs conclusively reject the Heston model which predicts that

volatility of volatility is constant, independent of volatility level.

n

n

This is very intuitive; vols should move around more if the volatility level is

100% than if it is 10%

The regression of VIX volatility vs VIX level gives 0.67 for the SPX

To interpret the result of the regression of skew vs volatility level, we

need to do some more work...

n

dv ~ v v dZ

at-the-money variance skew should satisfy

v

v

k k = 0

k

Delta is of the form N (d1 ) with d1 =

BS

T

2

k =0

v

BS

= 2 BS

k k = 0

k k =0

Referring back to the regression result, we get = / 2 0.82 . The two

estimates are not so far apart! Both are between lognormal and 3/2.

n

Once again, we note that the shape of the implied volatility surface

generated by a stochastic volatility model does not strongly depend on

the particular choice of model.

Given this observation, do stochastic volatility models fit the implied

volatility surface? The answer is more or less. Moreover, fitted

parameters are reasonably stable over time.

For very short expirations however, stochastic volatility models certainly

dont fit as the next slide will demonstrate.

Short Expirations

n

expiration) and various possible fits of the volatility skew formula:

ATM skew

t

0.5

1.5

-0.2

-0.4

-0.6

-0.8

-1

We see that the form of the fitting function is too rigid to fit the observed

skews.

Jumps could explain the short-dated skew!

n

implied distribution have quite different shapes.

The size of the volatility of volatility parameter estimated from fits of

stochastic volatility models to option prices is too high to be consistent

with empirical observations

SV versus SVJJ

n

Duffie, Pan and Singleton fitted a stochastic volatility (SV) model and a

double-jump stochastic volatility model (SVJJ) to November 2, 1993

SPX options data. Their results were:

J

J

J

v

J

SV

-0.70

0.019

6.21

0.61

v0

10.1%

SVJJ

-0.82

0.008

3.46

0.14

0.47

-0.10

0.0001

0.05

-0.38

8.7%

SV!

n

characteristic function T (u ) = E[ ei u xT ].

The volatility skew is given by the formula (Gatheral (2002)):

BS

k

= e BS T / 8

2

k =0

2 1

T

du

u Im[T (u i / 2)]

u2 +1 / 4

T SV (u ) = exp {C (u , T ) v + D(u , T ) v}

parameters , , .

Adding a jump in the stock price (SVJ) gives the characteristic function

T SVJ (u ) = T SV (u ) T J (u )

with T J (u ) = exp iu J T e +

Jim Gatheral, Merrill Lynch, February-2003

/2

1 + J T e

i u u 2 2 / 2

)}

SVJJ

n

function (Matytsin (2000)):

T SVJ (u ) = T SV (u ) T J (u ) T JV (u )

with

T JV (u ) = exp v J T e i u u

2

/2

)}

I (u ) 1

1 T

2 V V D (u ,T )

e z dz

V D (u ,T )

where I (u ) = d t e

=

0

T

p+ p 0

(1 + z / p+ )(1 + z / p )

n

With parameters

SVJ

-0.025

-0.05

SVJJ

SV

-0.075

-0.125

-0.15

10

n

SV and SVJ skews essentially differ only for very short expirations

0.05

0.1

0.15

0.2

-0.025

-0.05

-0.075SV

SVJ

-0.1

-0.125

-0.15

SVJJ

0.25

n

Recall that variance in the Heston model follows the SDE (dropping the

drift term)

dv v dZ

n

2 d dZ

n

So

d

n

dZ

2

t 2%

2

per day.

A more typical fit of Heston to SPX implied volatilities would give 0.80

implying a daily move of around 2.5 annualized volatility points per day.

Historically, the daily move in short-dated implied volatility is around

1.5 volatility points as shown in the following graph.

20 Day Standard Deviation of VIX Changes

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

05/90

09/91

01/93

06/94

10/95

03/97

07/98

12/99

04/01

09/02

n

should be able to get from the statistical measure to the risk neutral

measure using Girsanovs Theorem

SV fitted parameter.

Finally, in the few days prior to SPX expirations, out-of-the money

option prices are completely inconsistent with the diffusion assumption

n

skews, introducing jumps introduces more parameters and this is not

necessarily a good thing. For example, Bakshi, Cao, and Chen (1997

and 2000) find that adding jumps to the Heston model has little effect on

pricing or hedging longer-dated options and actually worsens hedging

performance for short expirations (probably through overfitting).

Different authors estimate wildly different jump parameters for simple

jump diffusion models.

Log returns over 4%

8.00%

6.00%

4.00%

Log Return

2.00%

-15.00%

-10.00%

-5.00%

0.00%

0.00%

-2.00%

-4.00%

-6.00%

-8.00%

Volatility Change

5.00%

10.00%

15.00%

Vol changes over 6%

6.00%

4.00%

Log Return

2.00%

-15.00%

-10.00%

-5.00%

0.00%

0.00%

-2.00%

-4.00%

-6.00%

-8.00%

Volatility Change

5.00%

10.00%

15.00%

n

move in volatility

If there is a large move, more large moves follow i.e. volatility must jump

n

models with stable increments

process to the integral of a CIR process trading time again.

The split between jumps and and diffusion is somewhat ad hoc in SVJJ

implied volatilities.

n

x =

n

We can always either buy an option or replicate it by delta hedging until

expiration: in equilibrium, implied volatilities should reflect this

If we delta hedge, each rebalancing trade will move the price against us

by

=

ADV

n S

= S

ADV

instantaneous volatility

2

1 2

S

t

n

variance along the most probable path (see Gatheral (2002))

BS

t /T

K

with S%t S 0 .

S0

1T 2 %

( K , T ) ( St , t ) dt

T 0

33.00%

32.00%

31.00%

30.00%

32.00%-33.00%

31.00%-32.00%

29.00%

28.00%

30.00%-31.00%

29.00%-30.00%

28.00%-29.00%

27.00%-28.00%

26.00%-27.00%

27.00%

25.00%-26.00%

26.00%

20

70

120

3m

6m

9m

12m

15m

18m

21m

24m

27m

30m

33m

36m

39m

42m

45m

48m

51m

54m

57m

60m

25.00%

170

42.00%

41.00%

40.00%

41.00%-42.00%

39.00%

40.00%-41.00%

39.00%-40.00%

38.00%

38.00%-39.00%

37.00%-38.00%

37.00%

36.00%-37.00%

35.00%-36.00%

36.00%

20

70

120

3m

6m

9m

12m

15m

18m

21m

24m

27m

30m

33m

36m

39m

42m

45m

48m

51m

54m

57m

60m

35.00%

170

n

We see that the shape of the implied volatility surface should reflect the

structure of open delta-hedged option positions.

In particular, if delta hedgers are structurally short puts and long calls,

the skew will increase relative to a hypothetical market with no frictions.

volatility models to the market can be ascribed to liquidity effects.

n

volatile than long-dated implied vol.

Significant at-the-money skew

volatility skews

High implied volatility of volatility

volatility

Anti-correlation of volatility moves

and log returns

Volatility of volatility increases with

volatility level

Jumps

Stock volatility depends on the

strikes and expirations of open deltahedged options positions.

Conclusions

n

continuous time extensions of simple but realistic discrete-time models

of stock trading.

Stylized features of log returns can be related to empirically observed

features of implied volatility surfaces.

By carefully examining the various stylized features of option prices and

log returns, we are led to reject all models except SVJJ

Investor risk preferences and liquidity effects also affect the observed

volatility skew so SV-type models may be misspecified and fitted

parameters unreasonable.

References

n

Clark, Peter K., 1973, A subordinated stochastic process model with finite

variance for speculative prices, Econometrica 41, 135-156.

Duffie D., Pan J., and Singleton K. (2000). Transform analysis and asset pricing

for affine jump-diffusions. Econometrica, 68, 1343-1376.

Geman, Hlyette, and Thierry An, 2000, Order flow, transaction clock, and

normality of asset returns, The Journal of Finance 55, 2259-2284.

Gatheral, J. (2002). Case studies in financial modeling lecture notes.

http://www.math.nyu.edu/fellows_fin_math/gatheral/case_studies.html

Heston, Steven (1993). A closed-form solution for options with stochastic

volatility with applications to bond and currency options. The Review of Financial

Studies 6, 327-343.

Leland, Hayne (1985). Option Pricing and Replication with Transactions Costs.

n

Mathematica Code, Finance Press.

Matytsin, Andrew (2000). Modeling volatility and volatility derivatives, Cirano

Finance Day, Montreal.

http://www.cirano.qc.ca/groupefinance/activites/fichiersfinance/matytsin.pdf

Wiggins J.B. (1987). Option values under stochastic volatility: theory and

empirical estimates. Journal of Financial Economics 19, 351-372.

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