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Original Title: Implied Risk-Neutral Distribution as a Closed-Form Function of the Volatility Smile

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Bertrand TAVIN ∗

Université Paris 1 - Panthéon Sorbonne

bertrand.tavin@univ-paris1.fr

January 26, 2011

Abstract

The aim of this paper is to obtain the risk-neutral density of an underlying asset price as a

function of its option implied volatility smile. We derive a known closed form non-parametric

expression for the density and decompose it into a sum of lognormal and adjustment terms.

By analyzing this decomposition we also derive two no-arbitrage conditions on the volatility

smile. We then explain how to use the results. Our methodology is applied first to the pricing

of a portfolio of digital options in a fully smile-consistent way. It is then applied to the fitting

of a parametric distribution for log-return modelling, the Normal Inverse Gaussian.

JEL Classification : C14, C52, G13.

Contents

1 Introduction and financial framework 2

4 Applications 12

4.1 Pricing of Digital Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

4.2 Fitting a Parametric Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

5 Conclusion 17

A Appendix 19

A.1 Proof of 2.9 and 2.10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

A.2 Expression of the log-return density . . . . . . . . . . . . . . . . . . . . . . . . . 20

A.3 Computation of Moments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

∗ Acknowledgements : I am grateful to my PhD supervisor Prof. Patrice PONCET (ESSEC Business School)

for his comments and helpful discussions. I also thank Peter CARR and Jens JACKWERTH for their comments

on an earlier version. All remaining errors are mine. Contact : PRISM - EA4101 17 rue de la Sorbonne 75005

Paris France

1 Introduction and financial framework

The knowledge of the risk-neutral density of an asset price is of great interest for researchers

and market practitioners. It has applications such as option pricing and analysis of market

information. Following the seminal result of Breeden and Litzenberger in [7] (Breeden &

Litzenberger, 1978) the study of risk-neutral densities is the topic of an important literature.

The great majority of this literature details approaches where risk-neutral density is obtained

from option prices. See among others [17] (Jackwerth & Rubinstein, 1996) [2] (Aı̈t-Sahalia

& Lo, 1998) and [11] (Figlewski, 2010). See also [16] (Jackwerth, 2004) for a detailed review

of literature and methodologies. In [6] (Bliss & Panigirtzoglou, 2002) authors recommend

an intermediary step where prices are converted to implied volatility to be smoothed and then

converted back to prices for the density to be computed. [21] (Kermiche, 2009) uses this

approach to construct the evolution over time of the risk-neutral density implied in CAC40

options and performs a principal component analysis to study its behavior.

Our approach to compute risk-neutral density is much simpler because it involves only one

step as we consider implied volatility as the available market data for options. Monitoring an

options market through implied volatility can be seen as more convenient than doing it through

prices. A first reason is that implied volatility can be instantly compared across strikes, where

prices need to be adjusted for the underlying price before being compared. Another reason is

that, on some markets, options are negotiated in terms of implied volatility instead of price. For

example this convention is in use for over-the-counter currency options. See [22] (Lee, 2005)

who also advocates using implied volatility to represent options data.

In this paper we propose a methodology to directly build a risk-neutral density from implied

volatility data. We take the Breeden-Litzenberger formula, see [7] (Breeden & Litzenberger,

1978), as starting point and derive a known result that can be seen as an implied volatility version

of it. This result has already been obtained in [15] (Jackwerth, 2000) and [8] (Brunner &

Hafner, 2003).

It is possible to obtain this implied volatility version because there is a one to one relation

between option price and implied volatility. This one to one relation is Black-Scholes formula, see

[5] (Black & Scholes, 1973), or Black’s formula, see [4] (Black, 1976), both seen as functions

of the volatility parameter σ (other parameters and variables held constant).

The paper is organized as follows. In the sequel of section 1 we explain the financial setup. In

section 2 we derive a closed form expression of the underlying asset price’s risk-neutral density as

a function of the volatility smile and make some comments on its terms. In section 3 we examine

how to use the formula and provide a numerical example. In section 4 we apply our method

to the pricing of a portfolio of digital options. In section 5 we study how to fit a parametric

distribution for log returns, the Normal Inverse Gaussian (NIG), directly to the volatility smile

using the formula and avoiding the computation of option prices.

We consider a complete financial market in continuous time where an asset S paying no

dividends is traded. We denote St its time t price. European vanilla options on S are also

traded. A strike K, maturity T , vanilla option pays at time T

+

CT = (ST − K) for a Call option

PT = (K − ST )+ for a Put option

We consider that a money market and zero-coupon bonds are available for trading. We

denote n(t) the time t value of the money market account (with n(0) = 1) and B(t, T ) the time

t price of the ZC bond maturing at time T . The money market account is an asset earning the

instantaneous risk-free rate, which is assumed to follow a stochastic process rt (t ≥ 0):

Z t

n(t) = exp rs ds (1.1)

0

As we suppose that our market is free of arbitrage, there exists a risk-neutral probability Q

equivalent to the true (historical) probability P. This probability is associated with (n(t), t ≥ 0)

as numéraire. Asset prices can be written as expectations, under Q, of their discounted payoffs.

" Z T !#

Q 1 Q

B(0, T ) = E = E exp − rs ds (1.2)

n(T ) 0

" Z T ! #

CT +

C0∗ = EQ = EQ exp − rs ds (ST − K) (1.3)

n(T ) 0

" Z T ! #

∗ Q PT Q +

P0 = E = E exp − rs ds (K − ST ) (1.4)

n(T ) 0

When interest rates are stochastic it is more convenient to work with the forward-neutral

probability QT associated with T , the maturity of the European options. QT is the probability

associated with (B(t, T ), t ≥ 0) as numéraire:

= = (1.5)

dQ B(0, T ) n(T ) B(0, T )n(T )

h i

+

C0∗ = B(0, T )EQT [CT ] = B(0, T )EQT (ST − K) (1.6)

h i

+

P0∗ = B(0, T )EQT [PT ] = B(0, T )EQT (K − ST ) (1.7)

For details on this change of probability, see chap. 11 and 19 in [25] (Portait & Poncet,

2010). In the sequel, we work with undiscounted option prices, defined as

C0∗ h

+

i P0∗ h

+

i

C0 = = EQT (ST − K) P0 = = EQT (K − ST ) (1.8)

B(0, T ) B(0, T )

Considering a vanilla option price as a function of strike and maturity, the Breeden-Litzenberger

formula links φT , the risk-neutral density of ST , with a second order partial derivative of this

function. For a fixed T > 0, and ∀k ≥ 0

1 ∂2C ∗ 1 ∂2P ∗

φT (k) = 2

(k, T ) = (k, T ) (2.1)

B(0, T ) ∂K B(0, T ) ∂K 2

3

This formula is key to obtain Dupire’s equation for local volatility models, see [9] (Dupire,

1993) or to reveal anticipations of market participants embedded in option prices, see [18]

(Jondeau & Rockinger, 2000). With undiscounted option prices, C and P , the formula

simplifies to

∂2C ∂2P

φT (k) = 2

(k, T ) = (k, T ) (2.2)

∂K ∂K 2

In our stochastic interest rates setting φT is the density of ST under QT the T -forward

neutral probability. When rates are deterministic, the forward and risk-neutral probabilities are

identical, that is QT = Q ∀T ≥ 0.

Whether interest rates are deterministic or not does not matter here. Breeden-Litzenberger

formula gives the underlying density under the relevant pricing measure. So that the price of a

European claim v paying h(ST ) at time T can always be written as

+∞ +∞

∂2C

Z Z

v0∗ = B(0, T ) h(x)φT (x)dx = B(0, T ) h(x) (x, T ) dx (2.3)

0 0 ∂K 2

contract written on S and expiring at time T . As ST = FTT , we have

+ + + +

CT = (ST − K) = FTT − K PT = (K − ST ) = K − FTT

St

The time t forward price of S is FtT = B(t,T ) (with t ∈ [0, T ]). It is a martingale under QT .

Under the assumption of a constant volatility geometric Brownian motion diffusion for F ,

Black’s formula holds, see [4] (Black, 1976). The undiscounted call price given by Black’s

formula at time t = 0 is

ln F 1 √ √

d0 (F, σ, K, T ) = √K − σ T d1 = d0 + σ T

σ T 2

where N is the cumulative distribution function of a standard Gaussian:

Z x 2

1 t

N : x 7−→ N (x) = √ exp − dt (2.5)

2π −∞ 2

This function is not known in closed form but fast and accurate approximations are available,

see for example Chap. 26 in [1] (Abramovitz & Stegun, 1972).

Black’s formula seen as a function of the volatility (σ 7−→ CB (F, σ, K, T )) is strictly increas-

ing. Hence from any observed call price it is possible to numerically back out a unique implied

volatility parameter by inverting this function. Observed option prices are market prices or

model outputs.

Practitioners represent vanilla options market data as implied volatility because it is easier

to interpret and to monitor. For a given maturity, implied volatility as a function of strike is

not constant and often smile shaped or skewed. It is usually called volatility smile. Although

4

this fact invalidates the assumption behind Black’s formula it is still possible to use it to express

observed prices with a strike dependent volatility parameter

In the right hand side of (2.6) the strike dependence is twofold. Plugging this representation

of observed prices into formula (2.2) should allow us to obtain the risk-neutral density of ST as

a function of the volatility smile. The second order derivative of C with respect to K will be

expressed with partial derivatives of Black’s formula with respect to K and σ. Applying twice

the chain rule for partial derivatives leads to

∂C ∂CB ∂CB ∂σ

= + (2.7)

∂K ∂K ∂σ ∂K

2

∂2C ∂ 2 CB 2

∂ 2 CB ∂σ ∂CB ∂ 2 σ

∂ CB ∂σ

φT = = +2 + + (2.8)

∂K 2 ∂K 2 ∂σ∂K ∂K ∂σ 2 ∂K ∂σ ∂K 2

Partial derivatives of CB involved in (2.8) are known in closed form. They are similar to the

Greeks in Black’s model: Gamma and Vanna wrt strike, Vomma (also called Volga) and Vega.

∂ 2 CB n (d0 ) ∂ 2 CB n (d0 ) d1

= √ = (2.9)

∂K 2 Kσ T ∂σ∂K σ

∂ 2 CB d0 d1 √ ∂CB √

= n (d1 ) F T = n (d1 ) F T (2.10)

∂σ 2 σ ∂σ

∂N

where n = ∂x is the probability density function of a standard Gaussian.

2

1 x

n : x 7−→ n(x) = √ exp −

2π 2

Proof. see Appendix A.1

As K 7−→ σ(K, T ) is the smile function, partial derivatives of σ involved in (2.8) make it

dependent of the volatility smile, unsurprisingly. Graphically they correspond to the smile slope,

convexity and squared slope. It is interesting to remark that only the first two derivatives of

the smile are needed to express the risk-neutral density. We define now G = G(K, T ) and

H = H(K, T ) as the smile slope and convexity (with respect to strike) at point (K, T ).

∂σ ∂2σ

=G =H (2.11)

∂K ∂K 2

Substituting (2.9), (2.10) and (2.11) in (2.8) we get the density as a closed form non-

parametric function of the implied volatility smile

√

n (d0 ) n (d0 ) d1 d0 d1

φT = √ + 2G + G2 + H n (d1 ) F T (2.12)

Kσ T σ σ

This formula is also derived in [15] (Jackwerth, 2000) where it is used to obtain risk aversion

functions, and in [8] (Brunner & Hafner, 2003) where it is used in the context of a no-arbitrage

analysis of the volatility smile.

5

We now rearrange the above formula to yield the key result of the paper decomposing φT as

a lognormal density term f plus two adjustment terms A1 and A2 .

in Black’s model with a volatility parameter equal to σ0 = σ(F, T ), the ATM implied volatility

(an option is said At The Money if struck at F ). A1 is a level adjustment term, accounting

for the difference between ATM implied volatility σ0 and its value at strike. And A2 is also an

adjustment term, accounting for the slope and convexity of the smile. These terms are written

1

f (k) = fLN k; ln F − σ02 T, σ02 T

2

1 1 1

A1 (k) = √ n (d0 (F, σ(k), k, T )) − n (d0 (F, σ0 , k, T ))

k T σ(k) σ0

√

n (d0 ) d1 d0 d1

A2 (k) = 2G(k) + G(k)2 + H(k) n (d1 ) F T

σ(k) σ(k)

The function x 7−→ fLN x; m, s2 is the density function of a lognormal distribution with

2 !

2

1 1 ln x − m

fLN x; m, s = √ exp −

xs 2π 2 s

Option traders usually analyze the implied volatility smile in three steps, examining well

known trading strategies. The first step is to check the ATM level, kept as a reference. In terms

of options trading it usually corresponds to an ATM straddle1 strategy. The second is to compare

the implied volatility at a specified strike K with the ATM reference. It corresponds to a call

spread2 (or put spread) strategy with one option struck at F and the other at K. The third step

is to analyze the overall shape of the volatility smile, its slope and convexity. That is done with

a risk reversal strategy3 for the slope and with a butterfly4 for the convexity.

The decomposition (2.13) of the density as a closed form function of the smile is sound and

makes sense financially because it is built exactly on the same three steps.

Pursuing further the analysis of (2.13) we derive no-arbitrage conditions on adjustment terms.

For φT to be a proper probability density function it should integrate to 1 on R+ and be positive

everywhere. That is

Z +∞

φT (k)dk = 1

0

φT (k) ≥ 0 ∀k ≥ 0

1A long ATM Straddle involves a call and a put, both long and struck at F .

2A Call Spread involves two calls, a long and a short, with different strikes.

3 A Risk Reversal involves a long call, struck higher than F , and a short put, struck lower than F .

4 A long Butterfly involves two long calls, struck higher and lower than F , and two short calls, struck at F .

6

This constraint on the density function is used in [8] (Brunner & Hafner, 2003). See also

[22] (Lee, 2005) who provides no-arbitrage bounds on the slope of the volatility smile.

As f already is a probability density function, it verifies

Z +∞

f (k)dk = 1

0

f (k) ≥ 0 ∀k ≥ 0

Hence we bring out two no-arbitrage conditions on the volatility smile. The first one is global.

The second one is local and holds at any particular point.

Z +∞

(A1 (k) + A2 (k)) dk = 0 (2.14)

0

The particularity of the above two results is to link at the same time the level, slope and

convexity of the volatility smile.

To work with the risk-neutral density formula (2.13) one needs implied volatility values at any

positive strike. Market data for traded options is only available at discrete strike points. The

implied volatility smile corresponding to real market data is a set of points instead of a continuous

curve. So we need an interpolation/extrapolation engine for the implied volatility : that is a

technique to produce a continuous smile, given a discrete market data set.

We consider three different techniques, which correspond to different approaches to smile gen-

eration. Many techniques are acceptable for that purpose. We choose to present and implement

three classical techniques. The first smile generation technique we consider is a parametrization

based on the implied volatility formula derived in stochastic volatility SABR model, introduced

by [14] (Hagan et al., 2002). We take the version of the formula proposed in [24] (Obloj,

2008) because it has less occurrence of arbitrage at very low strikes than Hagan’s version. This

parametrization works with 3 parameters (α0 , ρ, v) plus a fixed fourth parameter β.

Under SABR parametrization, implied volatility is written, for K 6= F

!!

F

1 (1 − β)2 α20

v ln K 1 ρβα0 v 2 − 3ρ2 2

σSABR (K, F ) = √ 1+T + 1 + v

1−2ρz+z 2 +z−ρ 24 (F K)(1−β) 4 (F K) 2 (1−β) 24

ln 1−ρ

(3.1)

and for K = F

!!

α0 1 (1 − β)2 α20 1 ρβα0 v 2 − 3ρ2 2

σSABR (F, F ) = 1−β 1+T 2(1−β)

+ (1−β)

+ v

F 24 F 4F 24

where

v F (1−β) − K (1−β)

z=

α0 1−β

7

The second smile generation technique is the SVI parametrization proposed in [13] (Gatheral,

2004). SVI stands for Stochastic Volatility Inspired. This parametrization is arbitrage free and

works with 5 parameters (a, b, v, ρ, m). Under SVI parametrization, implied volatility is written

v

u s !

1 u K K 2 2

σSV I (K, F ) = √ t a + b ρ ln −m + ln −m +v (3.2)

T F F

SABR and SVI parametrization need to be calibrated to the available market smile points. It

is done by minimizing the sum of squared errors on volatility values using a deterministic, gradient

based, optimization routine (Levenberg-Marquardt algorithm). We consider that market data is

available for a number N of strikes. Calibration is done by solving the following minimization

programs

N

2

X

P1 : min (σSABR (Ki , T ) − σMarket (Ki , T ))

(α,ρ,v)

i=1

N

(σSV I (Ki , T ) − σMarket (Ki , T ))2

X

P2 : min

(a,b,v,ρ,m)

i=1

where implied volatility is built as a piecewise polynomial function of degree three. Implied

volatility at strike K is written

N −1

σCS (K) = p1 (K)1]0,K1 [ (K) + pi (K)1[Ki ,Ki+1 [ (K) + pN −1 (K)1[KN ,+∞[ (K)

X

(3.3)

i=1

N −1

where (pi )i=1 are polynomials of degree three defined as

3 2

pi (X) = αi (X − Ki ) + βi (X − Ki ) + δi (X − Ki ) + γi

The cubic spline method needs no actual calibration but it is necessary to compute M , the

matrix of coefficients. This is done by solving a set of linear equations. For details see Chap 2.

in [27] (Stoer and Burlirsch, 1993) and Chap. 3 in [26] (Press et al., 2007).

α1 β1 δ1 γ1

.. .. .. ..

. . . .

M = αi

βi δi γi

. .. .. ..

.. . . .

αN −1 βN −1 δN −1 γN −1

The advantage of this approach is a perfect fit to the market data points but the drawback

is the possibility of non regularity in high order derivatives. This occurs when data is not very

8

smooth. Although the use of cubic spline, as a smile generation engine, can give rise to numerical

instabilities we present the results obtained with it to illustrate that the choice of parametrization

method is crucial because it can seriously affect the results.

Figure 1 shows implied volatility market data points and the smile curves produced with

fitted smile generation engines. The considered maturity T is one year and the underlying has

a T -forward value normalized at 100. It can be noted that between data points smile curves are

close to each other, but away from data points differences are noticeable and due to the different

behaviors of parametrization methods.

0.8

0.7

0.6

0.5

σimp

0.4

0.3

0.2

0.1

0 20 40 60 80 100 120 140 160 180 200

K

Market Data

SABR

SVI

Cubic Spline

Figure 2 shows the risk-neutral density obtained using our method (with the different smile

engines). Lognormal density corresponding to Black’s model is plotted as a reference. Non-

parametric density curves are significantly different from the lognormal one. Compared to it

they are skewed to the left and the cubic spline curve has irregularities around its maximum.

Figure 3 shows the total adjustment term A1 + A2 and the no-arbitrage bound correspond-

ing to the local condition (2.15). The three plotted curves are above the no-arbitrage bound,

illustrating that the condition is met.

Figures 4 and 5 show the details of adjustment terms A1 and A2 respectively. For cubic spline

curves, we remark that the irregularities come from the shape adjustment term A2 .

9

0.03

0.025

0.02

φT

0.015

0.01

0.005

0

0 20 40 60 80 100 120 140 160 180 200

k

Black (with ATM vol)

SABR

SVI

Cubic Spline

−3

x 10

8

0

A1+A2

−2

−4

−6

−8

−10

0 20 40 60 80 100 120 140 160 180 200

k

SABR

SVI

Cubic Spline

No−arbitrage bound

10

−3

x 10

5

A1 2

−1

−2

−3

0 20 40 60 80 100 120 140 160 180 200

k

SABR

SVI

Cubic Spline

−3

x 10

8

0

A2

−2

−4

−6

−8

−10

0 20 40 60 80 100 120 140 160 180 200

k

SABR

SVI

Cubic Spline

11

4 Applications

Our approach to expressing the risk-neutral density, detailed in sections 2 and 3, is now applied

to concrete cases. The first case we present is the pricing of a portfolio of digital options on

S in a fast and fully smile-consistent way. In the second we model the log-return of S using

a parametric distribution, the Normal Inverse Gaussian, and fit it to the non-parametric risk-

neutral distribution obtained from the volatility smile.

A European, maturity T , digital call (put) option is an option paying 1 at time T if ST is above

(below) K, its strike, and 0 otherwise.

DCT = 1{ST ≥K} for a digital call

DPT = 1{ST ≤K} for a digital put

Digital options are known to be sensitive not only to the implied volatility level at strike but

also to the shape of the volatility smile, see Chap. 17 in [28] (Taleb, 1997). Using a smiled

Black model to price it (a formula with a strike dependent volatility) is not appropriate because

the whole shape of the smile is not accounted for.,The undiscounted price of a digital call option

DC0 is obtained as

(4.1)

Z +∞

DC0 = QT ({ST ≥ K}) = φT (k)dk (4.2)

K

It can also be written directly using (2.3) with h(ST ) = 1{ST ≥K}

Z +∞ Z +∞

DC0 = 1{k≥K} φT (k)dk = φT (k)dk

0 K

Our method is particularly suitable for handling large portfolios of digital options because it

allows for a systematic pricing, consistent with the full smile. To obtain digital option prices it

is necessary to compute the integral in (4.2). A numerical quadrature method is needed because

φT , while known, has no parametric form. In our numerical implementation we use a Gauss-

Kronrod adaptative quadrature method. This method is appropriate because it is robust and

allows for a control of error.

Figure 6 below shows the prices of digital calls on S. Results obtained with the 3 different

smile interpolation techniques are plotted. Prices corresponding to Black’s model (with volatility

input equals to ATM value) are also shown as a reference. Market data is identical as in Part 3.

As expected, prices are substantially different from prices obtained with Black’s model, even

for the ATM struck option, because of the smile shape. Error made using Black’s price is not

negligible, it is positive or negative depending on the option’s strike. For this application, our

method is little sensitive to the choice of smile interpolation technique. If we except some irreg-

ularities, corresponding to cubic spline method, curves are close to each other. And differences

are small if compared with typical bid-offer spreads.

12

To plot figure 6, digital calls were priced (2000 different strikes) with 3 smile interpolation

methods: the computation is done in less than 20 seconds with a Matlab program on a personal

computer with no parallelization (Dual core CPU at 2.1GHz).

0.9

0.8

0.7

0.6

DC0

0.5

0.4

0.3

0.2

0.1

0

40 60 80 100 120 140 160

K

Black (with ATM vol)

SABR

SVI

Cubic Spline

ST

XT = ln (4.3)

S0

We first use the results obtained in Part 2 to get a non-parametric density for the log-

return. We then introduce the Normal Inverse Gaussian distribution (NIG hereafter) to model

the distribution of XT .

Considering that φT , the risk-neutral density of ST , is known and given by (2.13), it is possible

to express fnp the non-parametric density of XT as

Proof. See Appendix A.2

This approach to obtain the risk-neutral density of log-return from the risk-neutral density of

asset price is also used in [21] (Kermiche, 2009) and [11] (Figlewski, 2010). Figure 7 presents

fnp graphs for different smile construction techniques. Density obtained with Black’s model is

also plotted as a reference, it is a Gaussian density.

13

3

2.5

2

fnp(x)

1.5

0.5

0

−1 −0.8 −0.6 −0.4 −0.2 0 0.2 0.4 0.6 0.8 1

x

Black (with ATM vol)

SABR

SVI

Cubic Spline

Table 1 presents the values of the first four moments1 of XT , computed using the method

presented in Appendix A.3 and with the non-parametric density fnp . Moments of XT in Black’s

model are also computed to provide a check on the numerical quadrature method.

SABR -0.0194 0.0421 -1.2714 6.7719

SVI -0.0198 0.043 -1.2662 5.7697

Spline -0.0193 0.0429 -1.178 5.5898

Black -0.0179 0.0357 0 3

To model XT we now use the NIG distribution. It is parametric and we use fnp to determine

its parameter set θ = (α, β, µ, δ).

The NIG distribution was introduced in [3] (Barndorff-Nielsen, 1997). It allows for the

modelling of fat tails, skewness and kurtosis. For applications of the NIG distribution see [19]

(Kalemanova, Schmid & Werner, 2007) where authors use it in the context of CDO2 pricing.

See also [10] (Eriksson,Ghysels & Wang, 2009) where it is applied to the modelling of the

risk-neutral density of an underlying asset price. For details on its properties and implementation

see [20] (Kalemanova & Werner, 2006).

If we suppose the distribution of XT under QT to be a NIG, its density fθ is

1 For a definition of Mean, Variance, Skewness and Kurtosis see Appendix A.3.

2A CDO (Collateralized Debt Obligation) is a multi-name credit derivative.

14

δα exp(δγ + β(x − µ)) p

fθ (x) = p K1 α δ 2 + (x − µ)2 x∈R (4.5)

π δ 2 + (x − µ)2

p

γ = α2 − β 2 and K1 is the second kind modified Bessel function of order 1, see Chap. 9 in

[1] (Abramovitz & Stegun, 1972).

We want to fit the NIG distribution of XT , that is the parameter vector θ, according to

the volatility smile considered to be the available market data. It can be done by matching

risk-neutral moments, computed numerically using fnp . This method takes advantage of the

relationship between moments and parameters of the NIG distribution. It is also used, for

example, in [10] (Eriksson,Ghysels & Wang, 2009).

α β µ δ

SABR 9.9596 -5.7498 0.1419 0.2282

SVI 68.0358 -62.5623 0.3956 0.1775

Spline 25.9729 -20.5437 0.3107 0.2553

The results in Table 2 appear to depend on the smile generation technique. This is because

the computation of moments is rather sensitive to it. In particular the kurtosis is significantly

higher for the SABR parametrization (see Table 1).

Another approach to fit the NIG parameters is to minimize the distance between the distri-

butions, that is the distance between fθ and fnp seen as elements of the set of probability density

functions, with fnp fixed and considered to be the true distribution. This method accounts for

the whole distribution but involves an optimization step.

To achieve the fitting we consider three different distance criteria :

the Hellinger distance

s 2

+∞

1

Z p q

DH (fθ , fnp ) = fθ (x) − fnp (x) dx (4.6)

2 −∞

the L2 -norm sZ

+∞

2

L2 (fθ , fnp ) = (fθ (x) − fnp (x)) dx (4.7)

−∞

+∞

fnp (x)

Z

DKL (fnp ||fθ ) = fnp (x) ln dx (4.8)

−∞ fθ (x)

It can be noted that H and L2 are proper distances. H lies within [0, 1] and L2 is a member

of the Lp − norms family.

The Kullback-Leibler divergence DKL has been introduced in information theory. DKL (F ||G)

quantifies the additional information needed to describe a reference model F , when a model G

is given. It is used in probability and statistics as a non-symmetric measure of dissimilarity

between distributions.

15

The optimization programs to solve are

θ=(α,β,µ,δ)

θ=(α,β,µ,δ)

θ=(α,β,µ,δ)

These are non linear minimization problems for a multivariate and real valued objective

function, solved with a downhill simplex algorithm. Values shown in Table 2, obtained by

moment matching, are used as seed to start the algorithm. Although it makes sense to use this

seed, the algorithm is not sensitive to it.

Table 3 shows the distance values associated to the NIG distributions with parameters used

as seed of the algorithm. Tables 4, 5 and 6 show the NIG parameters obtained after the mini-

mization, for different distance criteria and smile interpolation techniques.

Hellinger L2 KL

SABR 0.0419 0.0915 0.006

SVI 0.015 0.0166 0.0015

Spline 0.0504 0.1759 0.0289

Table 3: Distance between non-parametric density and NIG density (parameters in Table 2)

α β µ δ

Hellinger 25.2998 -19.6381 0.3044 0.2629

L2 26.5032 -20.3435 0.3171 0.2791

KL 24.7267 -19.1248 0.3003 0.262

α β µ δ

Hellinger 32.6036 -27.6054 0.3186 0.2127

L2 46.0199 -40.9847 0.3512 0.1904

KL 31.0953 -26.141 0.3127 0.2142

α β µ δ

Hellinger 30.2305 -25.4527 0.3048 0.208

L2 30.209 -26.4908 0.2851 0.1732

KL 18.2102 -13.9883 0.2365 0.2132

16

Solving the distance minimization problem is fast. To obtain Tables 4, 5 and 6 takes 20

seconds. All computations are done with a Matlab program on a personal computer with no

parallelization (Dual core CPU at 2.1GHz).

Figure 8 shows the risk-neutral NIG densities of log-return obtained after minimizing the

Kullback-Leibler divergence for the different smile generation techniques. Local differences ob-

served near their maxima illustrate the sensitivity of the results to the choice of the smile tech-

nique. Curves are globally similar to each other which confirm the stability of our approach.

2.5

1.5

fNIG(x)

0.5

0

−1 −0.8 −0.6 −0.4 −0.2 0 0.2 0.4 0.6 0.8 1

x

SABR

SVI

Cubic Spline

5 Conclusion

We have derived in this paper a closed form expression of an underlying asset price risk-neutral

density as a non-parametric function of the volatility smile. The obtained density formula has

been decomposed as a lognormal density, corresponding to Black’s model (fitted ATM), plus

two adjustment terms accounting for smile level and shape. In the way we have also underlined

two no-arbitrage conditions concerning the volatility smile. The implementation steps of our

approach have been detailed and numerical results have been provided in the context of practical

applications. It proves to be simple to implement and to perform well and fast on realistic market

data.

Our methodology to build risk-neutral density appears to be suitable for industrial as well

as research purposes. For example, a risk management department can use it to control the

valuation of a trading portfolio of European derivatives. It can also be used to obtain marginal

distributions when modelling the joint distribution of several underlying assets.

17

References

[1] Abramovitz, M. and I.A. Stegun (1972). Handbook of mathematical functions, Dover (10th

printing).

[2] Aı̈t-Sahalia, Y. and A. Lo (1998). Nonparametric Estimation of State-Price Densities Implicit

in Financial Asset Prices. The Journal of Finance, Vol. 53, No. 2 (Apr., 1998), pp. 499-547

[3] Barndorff-Nielsen, O.E. (1997). Normal Inverse Gaussian distributions and stochastic volatil-

ity modelling. Scandinavian Journal of statistics, Vol. 24 (1997), pp. 113

[4] Black, F. (1976). The Pricing of Commodity Contracts. Journal of Financial Economics, Vol.

3, No. 1, pp. 167-179

[5] Black, F. and M. Scholes (1973). The Pricing of Options and Corporate Liabilities. The

Journal of Political Economy, Vol. 81, No. 3 (May - Jun., 1973), pp. 637-654

[6] Bliss, R. and N. Panigirtzoglou (2002). Testing the stability of implied probability density

functions. Journal of Banking and Finance, Vol. 26, pp. 381-422

[7] Breeden, D. and R. Litzenberger (1978). Prices of State-Contingent Claims Implicit in Option

Prices. The Journal of Business, Vol. 51, No. 4 (Oct., 1978), pp. 621-651

[8] Brunner, B. and R. Hafner (2003). Arbitrage-free estimation of the risk-neutral density from

implied volatility smile. The Journal of Computational Finance, 7(1) pp. 75-106

[9] Dupire, B. (1993). Pricing and hedging with smiles. Proceedings of AFFI conference, La

Baule, June 1993

[10] Eriksson, A., Ghysels, E. and F. Wang (2009). The Normal Inverse Gaussian Distribution

and the Pricing of Derivatives. The Journal of Derivatives, Vol. 16 (Spring 2009), pp. 23-37

[11] Figlewski, S. (2010). Estimating the Implied Risk Neutral Density for the U.S. Market

Portfolio. In Volatility and Time Series Econometrics: Essays in Honor of Robert F. Engle,

Oxford University Press.

[12] Foata, D. et A. Fuchs (2003). Calcul des Probabilités, Dunod (2ème Ed.)

[13] Gatheral, J. (2004). A parsimonious arbitrage free implied volatility parametrization. Global

Derivatives conference, Madrid 2004.

[14] Hagan, P., D. Kumar, A. Lesniewski and D. Woodward (2002). Managing smile risk. Wilmott

Magazine July 2002, 84-108

[15] Jackwerth, J. (2000). Recovering Risk Aversion from Option Prices and Realized Returns.

The Review of Financial Studies, Vol. 13, No. 2 (Summer, 2000), pp. 433-451

[16] Jackwerth, J. (2004). Option-Implied Risk-Neutral Distributions and Risk Aversion. The

Research Foundation of the AIMR.

[17] Jackwerth, J. and M. Rubinstein (1996). Recovering Probability Distributions from Option

Prices. The Journal of Finance, Vol. 51, No. 5 (Dec., 1996), pp. 1611-1631

[18] Jondeau, E. and M. Rockinger (2000). Reading the smile: the message conveyed by methods

which infer risk neutral densities. Journal of International Money and Finance,Vol. 19 (2000),

pp. 885-915

18

[19] Kalemanova, A., Schmid, B. and R. Werner (2007). The Normal Inverse Gaussian Distri-

bution for Synthetic CDO Pricing. Journal of Derivatives, Spring 2007, Vol. 14, No. 3, pp.

80-94

[20] Kalemanova, A. and R. Werner (2006). A short note on the efficient implementation of the

Normal Inverse Gaussian distribution. Working Paper

[21] Kermiche, L. (2009). Dynamics of Implied Distributions: Evidence from the CAC 40 Options

Market. Finance, 2009, Vol. 30 Issue 2, pp. 63-103

[22] Lee, R. (2005). Implied Volatility: Statics, Dynamics and Probabilistic Interpretation. In

Recent Advances in Applied Probability, Springer.

[23] Merton, R. (1973). Theory of Rational Option Pricing. The Bell Journal of Economics and

Management Science, Vol. 4, No. 1 (Spring, 1973), pp. 141-183

[24] Obloj, J. (2008). Fine-tune your smile, correction to Hagan et al., Wilmott Magazine,

May/June 2008, pp. 102-109

[25] Portait, R. and P. Poncet (2009). Finance de marché, Dalloz (2ème Ed.)

[26] Press, W., Teukolsky, S., Vetterling, W. and B. Flannery (2007). Numerical Recipes, The

Art of Scientific Computing, Cambridge Press (3rd Ed.)

[27] Stoer, J. and R. Burlirsch (1993). Introduction to Numerical Analysis, Springer (2nd Ed.)

[28] Taleb, N. (1997). Dynamic hedging, Managing vanilla and exotic options. John Wiley &

Sons Inc, Wiley Finance Editions.

A Appendix

A.1 Proof of 2.9 and 2.10

First recall three usefull identities for greeks calculation

= = + T F n (d1 ) = Kn (d0 )

∂K ∂K ∂σ ∂σ

We then obtain

=F −K − N (d0 ) = −N (d0 )

∂K ∂d1 ∂K ∂d0 ∂K

=F −K = (F n (d1 ) − Kn (d0 )) + F n (d1 ) T = n (d1 ) F T

∂σ ∂d1 ∂σ ∂d0 ∂σ ∂σ

∂ 2 CB ∂N ∂d0 n (d0 )

=− = √

∂K 2 ∂d0 ∂K Kσ T

19

!

∂ 2 CB ∂N ∂d0 1 ln F 1√ n (d0 ) d1

=− = −n (d0 ) − 2 √ K − T =

∂σ∂K ∂d0 ∂σ σ T 2 σ

!

∂ 2 CB ∂n ∂d1 √ F

1√ √

2

1 ln K

1 d1

2

= F T = √ (−d1 ) exp − − 2 √ + T F T

∂σ ∂d1 ∂σ 2π 2 σ T 2

d0 d1 √

= n (d1 ) F T

σ

Let g be a monotone and differentiable function and X a random variable with density fX . Let

Y be the random variable defined as Y = g(X). Its density fY can be expressed as

∂ −1

fY : y 7−→ fY (y) = g (y) fX g −1 (y)

∂y

To obtain (4.4), all you need to do is to apply the above result with XT seen as a transfor-

mation of ST . That is

XT = g(ST )

with

x

g(x) = ln x>0

S0

g −1 (y) = S0 ey y∈R

∂ −1

g (y) = S0 ey y∈R

∂y

so that

fnp (y) = |S0 ey | φT (S0 ey ) = S0 ey φT (S0 ey ) y∈R

Considering a random variable X with fX its density function. Mean, Variance, Skewness and

Kurtosis the first four moments are defined, when they exist, as (respectively)

h i

2

m = E [ X] v = E (X − m)

" 3 # " 4 #

X −m X −m

s=E √ k=E √

v v

20

If X is Gaussian, s = 0 and k = 3. Those values are considered as references when analyzing

moments of a distribution.

The computation of (m, v, s, k) relies on the numerical computation of the following integral

for k = 1, 2, 3, 4

Z +∞

Ik = E X k = xk fX (x)dx

0

Once the Ik are computed for k = 1, 2, 3, 4, moment values are recovered sequencially using

the following identities

m = I1

v = I2 − m2

3

s = v − 2 I3 − 3mv − m3

3

k = v −2 I4 − 4msv 2 − 6m2 v − m4

Proof.

h i

2

= E X 2 − 2Xm + m2 = I2 − m2

v = E (X − m)

" 3 #

X −m 3

= v − 2 E X 3 − 3X 2 m + 3Xm2 − m3

s=E √

v

3 3

= v − 2 I3 − 3m v + m2 + 2m3 = v − 2 I3 − 3mv − m3

" 4 #

X −m

= v −2 E X 4 − 4X 3 m + 6X 2 m2 − 4Xm3 + m4

k=E √

v

3

= v −2 I4 − 4m sv 2 + 3mv + m3 + 6m2 v + m2 − 3m4

3

= v −2 I4 − 4msv 2 − 6m2 v − m4

21

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