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Motivation: illiquid cross currency options
Local volatility calibration: choice of variables

The 2D PDE for the price
Conclusion and perspectives
Local volatility surfaces for illiquid currency pairs
Gabriel Turinici, Marc Laillat
Universite Paris Dauphine and Adn Analytics, Thomson Reuters
Conference on Numerical Methods in Finance, Paris-ENPC,
Apr. 17th, 2009
Gabriel Turinici, Marc Laillat Local volatility surfaces for illiquid currency pairs
1D Black-Scholes PDE
Outline
1
2
Algorithm
Results
3
Dirichlet boundary conditions
Using a Dupire style equation
4
Illiquid cross currency options
In practice we know the price of many FOREX options for major
currency pairs: EUR/USD, JPY/USD, GBP/USD, EUR/GBP, etc.
What about a rm wanting to hedge the risk of Japan yen (JPY)
versus e.g., New Zeeland $ (NZD) ?
They need an JPY/NZD option but only available are
S
1
= JPY/USD and S
2
= NZD/USD. What is the price of a
cross-currency JPY/NZD option ?
Price of a call option: 1D Black& Scholes PDE
Suppose NZD/JPY cross-rate S
t
follows the SDE
dS
t
/S
t
= (r q)dt + dW
t
(1)
Here r = interest rate for the rst currency (JPY), q= interest rate
for the second currency (NZD), =
JPY/NZD
is the volatility.
The price C follows the Black-Scholes PDE
t
C + (r q)S
S
C +

2
S
2
2

SS
C rC = 0 (2)
C(S, t = T) = (S
T
K)
+
. (3)
Price today is C(S
0
, t = 0).
JPY/NZD
is unknown and there are no /few options quoted (no or
illiquid market).
Price of cross-currency options: 2D Black-Scholes
t
c + S
1
S
1
c + S
2
S
2
c +
+
2
1
(S
1
)
2
2

S
1
S
1
c +

2
2
(S
2
)
2
2

S
2
S
2
c +
1,2
S
1
S
2
2
c
S
1
S
2
rc = 0 (4)
c(T, S
1
, S
2
) = S
2
[S
1
/S
2
K]
+
= [S
1
KS
2
]
+
. (5)
1
= r r
1
,
2
= r r
2
, r ,
1,2
are known.
Rq: if
1,2
is not known then procedure can be see as calibration of
it when c is known.
Rq: outperformer option = particular case, payo [S
1
S
2
]
+
.
More generally pair trading.
Price of cross-currency options: 2D Black-Scholes
Rq:
1
,
2
= constant then S = S
1
/S
2
follows the dynamics
dS
t
/S
t
= (r q)dt + dW
t
(6)
with =
_
2
1
+
2
2
2
1
2
thus one has result by Black&
Scholes analytic formula
To do :
local volatility calibration problem from quoted option prices
(on S
1
and S
2
) obtain the surfaces
1
and
2
solve the 2D PDE
Rq: also possible by Monte-Carlo, should get same result.
Algorithm
Results
Outline
1
2
Algorithm
Results
3
4
Algorithm
Results
Calibration: we have several prices quoted for dierent strikes K
and maturities T
: C
market
K
,T
. One needs to recover = (S, t)

such that C(S
0
, t = 0; K
, r , T
, (S, t)) = C
market
K
,T
for all .
t
C
+ (r q)S
S
C
+

2
S
2
2

SS
C
rC
= 0 (7)
C
(S, T
) = (S K
)
+
(8)
Procedure: automatic (because only an intermediary product) i.e.
results robust with respect to user parameters, numerically stable
w/r to input (even for hard cases e.g. JPY/USD), (fast), precise
(< 0.1% in implied vol).
Algorithm
Results
Calibration: what variables to chose
Existing literature: all invert the mapping C.
Coleman et Li, Verma: parametric setting
L. Jiang et al., Achdou & Pirroneau : control framework
(adjoints)
Lagnado et al. : constraints
Consider the mapping local to implied instantaneous variance
v =
2
V(v) = w = (
I
)
2
1
asymptotics: if lim
S0/
v(S, t) = v
/+
(t) then
lim
S0/
V(v)(S, t) =
1
t
_
t
0
v
/+
(s)ds, i.e. mapping is
LINEAR
2
for = (t) one can also prove numerical stability properties
Idea: use this mapping for inversion.
Algorithm
Results
Calibration: general penalization result
Theorem
Let H be a Hilbert (Banach) space and T : H R weakly
continuous with inf
vH
T(v) > (lower bounded). Denote
J
e
:= v
2
H
+ T(v). Then
1
the minimization problem inf
vH
J
(v) has at least one

solution v
2
one of the following alternatives is true
1 lim
0
v
H
= and in this situation inf
vH
T(v) has no
minimizer in H.
2 v
H
is bounded and in this case inf
vH
T(v) has at least one
solution on H. Moreover any limit point for 0 of the
sequence (v
is a solution of the problem

min
T()=min
vH
T(v)
H
. (9)
Algorithm
Results
Calibration: local to implied mapping
minimize the functional
J
(v) = v
2
L
2
+
L
=1
(V(v)(K
, T
) V(v
0
)(K
, T
))
2
(10)
Sequentially Quadratic Problem (SQP) (+ regularization,
constraints)
min
p
_
J
(v
k
)+D
v
J
(v
k
)(p)+
1
2
D
vv
J
(v
k
)(p, p)
v
k
+p K
_
(11)
Then one sets v
k+1
= v
k
+ p
k
(p
k
is the solution of the QP).
Gauss-Newton style approximation for each QP: only need D
v
V(v).
Rq: dumb projected gradient algorithm is also OK ... thus the
variables are important.
Algorithm
Results
Calibration: optimization algorithm
D
v
V(v)(K
, T
) = 2
_
V(v)(K
, T
)
1
I
l ,BS
D
v
C
. (12)
D
v
C
(S
0
, 0) =
S
2
2
(
SS
C
). (13)
For D
v
C use an adjoint ( Fokker-Planck)
t
+
S
((r q)S)
SS
(
vS
2
2
) + r = 0 (14)
(S, t = 0) =
S=S
0
. (15)
Rq.: only used in a weak sense thus numerics ok.
Expansion in a basis
v(S, t) =
ij
f
ij
(S, t). (16)
Algorithm
Results
Figure: Shape form.
Algorithm
Results
Figure: Benchmark from Andersen et al., Coleman et al. for S&P 500
options.
Algorithm
Results
Figure: Implied volatility surface for JPY/USD options dated March 18th
2008, courtesy of Thomson Reuters Financial Software.
Algorithm
Results
Figure: Local volatility surface for JPY/USD options dated March 18th
2008, courtesy of Thomson Reuters Financial Software.
Algorithm
Results
Figure: Local volatility surface for the South African Rand (ZAR) vs.
USD options Nov. 2008, courtesy of Thomson Reuters Financial
Software.
Outline
1
2
Algorithm
Results
3
4
The 2D PDE for the price: Dirichlet boundary conditions
Price of a cross-currency option follows the 2D PDE:
t
c + S
1
S
1
c + S
2
S
2
c +
+
2
1
(S
1
)
2
2

S
1
S
1
c +

2
2
(S
2
)
2
2

S
2
S
2
c +
1,2
S
1
S
2
2
c
S
1
S
2
rc = 0 (17)
c(T, S
1
, S
2
) = S
2
[S
1
/S
2
K]
+
= [S
1
KS
2
]
+
. (18)
Yet to chose : the boundary conditions: we use Dirichet ...
The 2D PDE for the price: boundary conditions
(green) S
1
/S
2
<< K: c(t, S
1
, S
2
) = 0;
(blue) S
1
/S
2
>> K: use put-call parity
c(t, S
1
, S
2
) = S
1
e
r
1
(Tt)
KS
2
e
r
2
(Tt)
(red) S
1
, S
2
both small/large :
1
,
2
are undetermined: we
take them constant and use the explicit Black-Scholes formula
Figure: The domain in S
1
/S
2
.
When prices are to be computed for many K, T one can use a
Dupire / Kolmogorov eqn. as in A. Conze, N. Lantos, O. Pironneau
Comm. Pure & Appl. Anal.(CPAA) 8(1), 195-208, 2009. For
t
P +
2
k=1
S
k
_
S
k
k
P
_
S
k
S
k
_
2
k
S
2
k
2
P
_

2
S
1
S
2
_
1,2
S
1
S
2
2
P
_
+ rP = 0 (19)
P(t = 0, S
1
, S
2
) =
S
1
=S
market,t=0
1
,S
2
=S
market,t=0
2
. (20)
BC: Dirichlet, zero for S
1
, S
2
far from initial values.
Then price is
_
R
2
+
P(T, S
1
, S
2
)(S
1
KS
2
)
+
dS
1
dS
2
.
Advantage: one PDE enough for all K, T (as Dupire). BUT: need
to solve a PDE with initial data a Dirac mass (use numerical
adjoint ).
Outline
1
2
Algorithm
Results
3
4
procedure tested on simple cases and approximations are ok;
future implementation w. Thomson Reuters under study.
further stability properties: techniques exist that render an
unique solution to the inverse pb.
Refs: preprints: scholar google search Gabriel Turinici
calibration and http://hal.archives-ouvertes.fr;
calibration local implied var.: to appear in J. Comp. Fi. (2009)
Acknowledgements : collaborators: Mohammed Aissaoui, Kalide
Brassier, Arthur Pham (Adn team of Thomson Reuters) ;
discussions: O. Pironneau (University Pierre et Marie Curie, Paris)

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Motivation: illiquid cross currency options

Local volatility calibration: choice of variables

. One needs to recover = (S, t)

(v) has at least one

is a solution of the problem

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