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A MONTE-CARLO APPROACH
`
PIERRE HENRY-LABORDERE
Abstract. In this paper, we compute the sensitivity according to a (local) deformation of the
Dupire local volatility [6]. This leads to an efficient projection of the Vega risk on vanilla options
that we illustrate by numerical experiments.
1. Introduction
The market is assumed to be made of N assets, the values of which are modeled in a risk-neutral
framework by a local volatility model [6] (in short LV). Under the (unique) risk-neutral measure
P, the dynamics reads :
dSt = St (t, St )dWt , < dWt , dWt >= dt , = 1, . . . , N
with (Wt )=1,...,N an N -correlated Brownian motion. We denote (Ft ) as the natural filtration of
W . For the sake of simplicity, we have assumed zero (deterministic) interest rates and dividends.
This assumption can be easily relaxed by considering the local martingale ft as introduced in [10]
(see equation 14). As the market is complete, the risk associated to the pricing of an option can
be canceled via a proper delta hedging strategy. However, the implied volatility (in short IV)
dynamics produced by the LV model is not consistent with the market and the model needs daily
recalibration of the LV. As a consequence, the hedging strategy is sensitive to the deformation of
the IV: we say that we have a Vega risk. In principle, this risk could be canceled by an appropriate
portfolio of vanilla options with a continuum of strikes and maturities. However, the computation
of the weights for each vanilla options is quite challenging. The traditional approach involves
only an analysis of the global Vega risk associated to a parallel deformation of the IV surface. A
straightforward extension of this approach, the so-called super-bucket analysis, involves the shift
of each individual point of the IV [2]. However, this local deformation is not arbitrage-free: the
square of the LV function can become negative. Therefore, we must rely on a local deformation of
the LV function. This method can be quite time-consuming as we need to recompute the fair price
of the exotic and vanillas for each local deformation. Furthermore, this can lead to an ill-posed
problem as the sensitivity matrix may be non-invertible. In order to overcome these difficulties, we
suggest a new approach based on two steps: First an analytical expression of the vanilla weights in
terms of the local gamma leading to a well-posed problem and secondly a Malliavin representation
of this local gamma leading to a fast Monte-Carlo (MC) computation. The first step was also
independently investigated by B. Dupire [7]. Finally, we illustrate numerically our algorithm on
various payoffs.
Key words and phrases. Malliavin calculus, Functional derivative, Vega hedging, Local volatility model, Libor
Market Model.
1
`
PIERRE HENRY-LABORDERE
2. Vega Hedging
We consider an infinitesimal deformation of the LV (, ) (, ) + (, ) and its impact on
the fair value of an exotic option O = E[] with a payoff = (St1 , . . . , Stn ) L2 (P) depending
on spot values at the dates {ti }i=1,...,n .
Assumption 1:
B = ( )=1,...,N are continuous twice differentiable functions with bounded Lipschitz derivatives
(in space) in order to ensure the existence of an unique strong solution.
B The matrix a := is assumed to satisfy an uniform ellipticity condition:
> 0 : X a(t, x)X |X|2 , (t, x, X) R+ (R+ )N RN
2.1. Local deformation. For use below, we introduce the Gateaux derivative [12] of O with
respect to this local deformation ()(, ):
Definition 2.1 (LV deformation). O is said to be Gateaux differentiable (along the admissible
direction + satisfying the above uniform elliptic condition for any ) with derivative O
if the following derivative exists
O lim
0
O ( + ) O()
Here O is seen as a map from a volatility function to R. Below, we note T K O (if it exists) such
that
Z tn
Z
O =
dT
dK (T, K)T K O
(1)
0
0
0
T K O
(2)
h
i
with OT = E |FT .
k=i+2
n
Y
dSi
i=1
where p(tk , Sk |tk1 , Sk1 ) is the transition density (which exists under Assump. 1) from tk1 to
tk . In the multi-dimensional case, the local Gamma is defined as
K 2 (T, K)2
loc (T, K)
N
X
=1
h
i
E0 ST ST (T, ST ) (T, ST )S2 S OT |ST = K 1tn T
T
A MONTE-CARLO APPROACH
T K O = K 2 (T, K)
loc (T, K)E0 (ST K)
For the aim of readability, proofs have been reported in the appendix.
2.2. Exact Vega weights. We try to cancel the variations induced by these infinitesimal deformations on the LV using a portfolio of vanilla options with a continuum of strikes and maturities
with weights (, ):
N Z
X
=1
tn
dT 0
dK 0 (T 0 , K 0 )C (T 0 , K 0 )
with C (T, K) the market value (at t = 0) of a call option on asset with strike K and maturity
T . Note that by construction, the LV model is calibrated to these market prices. We get for each
= 1, . . . , N :
Z tn
Z
T K O +
dT 0
(3)
dK 0 (T 0 , K 0 )T K C (T 0 , K 0 ) = 0
0
1 2
2 2
with L
T K T + 2 K (K ) the Fokker-Planck operator. The differentiations should be understood in the distribution sense.
We have added a subscript on to indicate that the deformation is performed around the LV .
Remark 2.5. It is obvious from the expression above that (T, K) = 0 for all T < t1 as
2
T p(T, S = K|S0 ) + 12 K 2 2 (T, K)K
p(T, S = K|S0 ) = 0.
Example 2.6 (Sanity check: European payoff (Stn )). We have
Z
2
loc (T, K) = (x)K
p(T 0 , x|T, K)1tn T dx
2
We obtain using (4) (T, K) = K
(K)(tn T ) as expected from a static replication strategy.
2.3. Smooth Vega weights. By construction, the weight (, ) is not a smooth function but a
distribution in D0 . In particular, for a call option with strike K 0 and maturity T 0 , one gets a Dirac
distribution (T, K) = (T T 0 )(K K 0 ) which is difficult to capture numerically.
2.4. Regularized kernel I. In order to overcome this numerical difficulty, we could smooth
0
0
:
(, ) by convolution with a regularized kernel (T , K |T, K) C
Z
Z
(T 0 , K 0 ) =
dT
dK (T 0 , K 0 |T, K)
(T, K)
0
`
PIERRE HENRY-LABORDERE
2.5. Regularized kernel II. A better alternative approach is to start from the fact that only a
small set of strikes and maturities are quoted on the market:
X
T ,K (ti , Ki )C(ti , Ki )
i,j
Here we have suppressed the subscript . Let us choose an interval [ti T , ti +T ][Ki K , Ki +
K ] centered on a (liquid) couple (ti , Ki ). Then as a heuristic choice, we take
Z ti +T
Z Ki +K
VBS (ti , Ki )T ,K (ti , Ki )
dT
dKVBS (T, K)LT K loc (T, K)
ti T
Ki K
with VBS (T, K) (resp. BS (T, K)) the Black-Scholes Vega (resp. Gamma) computed with the IV
T,K
BS
at (T, K). By using an integration by parts and the identities
T,K 2
LT K VBS (T, K) = BS
K BS (T, K)
T,K
VBS (T, K) = BS
T S02 BS (T, K)
we get
VBS (ti , Ki )
T ,K
(ti , Ki ) =
S02
Z
Ki +K
h
iti +T
T,K
BS
T BS (T, K)loc (T, K)
dK
ti T
Ki K
1
2
Z
ti +T
iKi +K
T,K
T,K
T K 2 (T, K)2 loc (T, K)K (BS
BS (T, K)) + BS
BS (T, K)K (K 2 (T, K)2 loc (T, K))
dT
h
Ki K
ti T
ti +T
Ki +K
dT
ti T
T,K
dKBS
K 2 BS (T, K)loc (T, K)
Ki K
(5)
Each integral can be reduced to a quadrature on [0, 1]. Below, we examine a method to compute
numerically loc (T, K) based on Malliavin calculus (for a short introduction to Malliavin calculus with similar computations, see [11]) which was introduced in finance by [9]. An alternative
approach, using the It
o functional calculus introduced by B. Dupire, can be found in [8].
3. Computation of the local Gamma loc (T, K)
3.1. Black-Scholes representation. Note that when the transition density is known, as is the
n
h S
X
(T ) KST p(ti+1 , Si+1 |T, ST (S = K))p(T, ST (S = K)|ti , Si ) i
T
(T,
K)
=
E
loc
K
(T )
p(T, S = K|S0i )p(ti+1 , Si+1 |ti , Si )
=1
This can be simplified a bit further using the explicit transition function:
h
p(ti+1 , Si+1 |T, K)p(T, K|ti , Si )
2
K 2 BS
(ti+1 T )loc (T, K) = E0 (S1 , . . . , Sn )
p(T, K|S0 )p(ti+1 , Si+1 |ti , Si )
i
1
1 + 2
2 1T [ti ,ti+1 ]
BS (ti+1 T )
where
= ln
Sti+1
K
1 2
+ BS
(ti+1 T )
2
A MONTE-CARLO APPROACH
!
!
Sti+1
1
ti+1 T BS
+ BS BS (ti+1 T )
=
ln
ti+1 ti BS
Sti
2
=1
Sti+1
T ti
K
ln
ln
Sti
ti+1 ti
Sti
Sti+1
Sti+1
1 2
T ti
K
ti+1 T
+ (BS ) (ti+1 T ) ln
ln
ln
=
ti+1 ti
Sti
2
Sti
ti+1 ti
Sti
M
X
3.2. Malliavins representation. In the general case, we need to rely on Malliavin calculus as
the probability density is not known. Here for the sake of simplicity, only results in the one-asset
case are written out. Extensions to the multi-dimensional case are straightforward.
Proposition 3.1 (Local Gamma). Under Assump. 1 and Cb2 (Rn+ ), we have
n
n
i
X
X
Y
Y
Y
t
t
t
(2)
(2)
i
j
|ST = K
i 2i (ti T )1tn >T +
ij
(7) loc (T, K) = E[
1
t
>T
n
YT
YT2
i=1
i,j=1
(2)
where the It
o (tangent) processes Yt and t
dYt
are defined by
(2)
dt
(2)
i
For numerical purposes, (ST K) appearing in the conditional expectation E[|ST = K has to
be replaced by a Gaussian kernel (ST K). Here we note that loc (T, K) depends on the Hessian
of the payoff, a quantity which could be quite difficult to compute numerically. This originates for
our irregular infinitesimal deformation irreg (s, Ss ) = (s T )(Ss K). We could compute the
local Vega O associated to a smooth deformation (s, S) (s, S) of the LV close to irreg :
Proposition 3.2 (Local Vega). Under Assump. 1,
n
h
i
X
(8)
O = E0 (St1 , . . . , Stn )
j
j=1
with
j
tj
tj1
tj
Ys
a(s)
dWs
S
(s,
Ss )
s
tj1
tj
(s, Ss )
(s,
Ss )
tj1
a(s)ds 1tj 1s (Ys S ln Ss (s, Ss ) 2s )(Zt0j Zs0 )
(Zt0j Zt0j1 )
tj
a(s)ds = 1 , j = 1, . . . , n
tj1
a(s)ds
`
PIERRE HENRY-LABORDERE
= St (t, St )dWt
dYt
(2)
dt
dZt0
(1)
dt
(2)
Remark 3.3 (Sanity check: Black-Scholes). Here we assume (t, S) = and (t, S) = . We get
Zt0
Yt
= S0 (Wt t)
St
=
S0
(2)
(1)
t
t
2
0
1
(2)
0
Zt0
S0
i
n
h
X
(Wtj Wtj1 )2
1
O = E0 (St1 , . . . , Stn )
(Wtj Wtj1 ) +
(tj tj1 )
j=1
(1)
Unfortunately, this expression requires the simulation of Zt0 and t for each deformation (, ).
For ease of implementation, we have decided to compute the weights for a constant volatility - say
BS
= 0.2. This is acceptable because if the weights depend strongly on the LV function (, ),
the Vega hedging should be unstable meaning that our Vega decomposition on vanillas should be
often re-balanced as the volatility changes.
Algorithm. Our algorithm can be summarized by the following steps for a payoff (St1 , . . . , Stn )
written on N assets.
(1) Simulate using constant volatilities ( i )i=1,...,N 1 and store the N assets at the dates
(ti )i=1,...,n .
(2) Compute the local Gamma using formula (6) or (7)2 on a space-time grid and then interpolate the result with splines. In practise, we take = 1/(12 2) and 100 points
min
max
in space. The range of the grid in space at T = k, i.e. [Sk
, Sk
], can
h be specified
max ] =
by looking at digital options computed with the constant volatilities: E0 1Sk >Sk
h
i
min
E0 1Sk <Sk
= 1 N (stdev) where N () is the normal cumulative distribution. We take
3 standard deviations.
(3) Compute the Vega weight as given by formula (5) (with K = 0.05, T = 1/(12 4)).
A MONTE-CARLO APPROACH
L
j
j
j=i+1
dLn
= n (t, Ln )dWtn
As each Libor volatility is sensitive only to a single caplet smile, we need only use a portfolio of
caplets with a continuum of strikes (with weights i ()):
n Z
X
dQi (K)C i (K)
i=1
i
C i (K) = P (0, ti )EP0 (Liti K)+ being the fair value of a caplet with maturity ti and strike K.
4.2. Vega hedging. We will consider the Gateaux derivatives i O along the local deformation
i (t, Li ) i (K)1t=ti . We note below (if it exists) i,K O satisfying
Z
i O =
i,K Oi (K)dK
0
n
k
j
X
n
(T
,
L
)
1
j
j
k OT k
kj
k,K O = i (K)P0tn E0P [(Lktk K)
2
k (T k , K)(1 + j Lj )
j=k+1
(9)
n
X
k
i (T k , Li )i<k<n ik
k , K)(1 + K)
(T
k
k
i=1
!
i OT k + 2
n
X
j (T k , Lj )
j=1
k (T k , K)
h
i
k
i (K)ik (K Q)P0tk EP0 (Lktk K)
2 k
k (K)ik (K Q)K
C (K)
kj OT k
`
PIERRE HENRY-LABORDERE
60%
50%
50%-60%
40%-50%
30%-40%
40%
20%-30%
10%-20%
30%
0%-10%
-10%-0%
20%
10%
0%
1.90
1.50
-10%
2-janv.-12
0.30
2-mars-12
2-sept.-11
ST
S0
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
2-mai-10
2-juil.-10
1.10
+
1 , T = 1Y and T = 2Y.
we deduce
Theorem 4.1 (Caplet weights). Under Assump. 1
k2 (K) =
k,K O
2 C k (K)
k (K)K
The computation of the local Gamma (9) can be simplified if we perform the deformation of the
LV at i (t, Li ) = i ( i Li + 1). For such a choice, the processes Xti = i Lit + 1 defines a log-normal
diffusion for which we can obtain an expression similar to (6).
5. Examples
5.1. Numerical Tests.
5.1.1. European payoffs. First, we test our algorithm on European payoffs, mainly call options
(Fig. 1), call spread options (Fig. 2) and variance swaps (Fig. 3, 4) assuming a constant volatility
BS = 20%.
5.1.2. Exotic options. Then, we consider an Asian option (Fig. 5) and American digital options
(Figs 6, 7). Finally, as an example with two assets, we take a basket option with equal weights
(Fig. 9) and a worst-off option (Fig. 8). We have taken N = 218 Monte-Carlo paths. All graphs
show at a point (T, K) the product of the (Black-Scholes) Vega with the smooth weight (T, K).
A MONTE-CARLO APPROACH
30%
20%
20%-30%
10%-20%
0%-10%
-10%-0%
-20%--10%
-30%--20%
-40%--30%
10%
0%
-10%
-20%
-30%
1.90
1.50
-40%
ST
S0
2-janv.-12
0.30
2-mars-12
2-sept.-11
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
2-mai-10
2-juil.-10
1.10
0.95
+
ST
S0
+
1.05 , T = 1Y
Vega Weight
14%
14%
12%
12%
12%-14%
10%-12%
8%-10%
6%-8%
4%-6%
2%-4%
0%-2%
-2%-0%
10%
10%
8%
8%
6%
6%
4%
2%
4%
0%
1.90
1.50
-2%
2%
2-mars-12
2-nov.-11
2-janv.-12
2-mai-11
2-juil.-11
2-sept.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
2-mai-10
2-juil.-10
1.10
0.70
0.30
0%
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12
VegaBS2Y/K^2
-2%
(2, K) at
Figure 3. 2Y log-swap. We have zoomed in on the Vega weights
T = 2 years and compared them again the Black-Scholes Vega divided by 1/K 2
as given by the static replication. We can see a perfect match.
5.2. Theoretical analysis of an example: Forward-start options. Let us consider a forwardstart option with payoff
+
St2
Q
St1
By using a Black-Scholes model with a constant volatility BS , the local Gamma is given by
Z
dS1
p(T, K|t1 , S1 )p(t1 , S1 |S0 )
loc (T, K) =
BS (t2 T, QS1 |K)
1T [t1 ,t2 ]
S1
p(T, K|S0 )
0
`
PIERRE HENRY-LABORDERE
10
14%
12%
12%
10%
10%-12%
8%-10%
6%-8%
4%-6%
2%-4%
0%-2%
-2%-0%
-4%--2%
10%
8%
8%
6%
4%
VEGAK 2Y
VegaBS/K^2
VegaK 1.9Y
6%
2%
4%
0%
2%
-2%
1.90
1.50
-4%
0%
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
2-janv.-12
-2%
0.30
2-mars-12
2-sept.-11
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-mars-11
2-nov.-10
2-janv.-11
2-mai-10
2-juil.-10
2-sept.-10
1.10
-4%
2
PT
Figure 4. 2Y variance swap with monthly returns T2 i=1 ln SSi+1
. We have
i
(2, K) at T = 2 years and compared them again
zoomed in on the Vega weights
the Black-Scholes Vega divided by 1/K 2 as given by the static replication. We
can see a good match.
6%
4%-6%
2%-4%
4%
0%-2%
2%
-2%-0%
-4%--2%
0%
-6%--4%
-2%
-8%--6%
-4%
-6%
1.90
1.50
-8%
2-janv.-12
0.30
2-mars-12
2-sept.-11
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-mars-11
2-nov.-10
2-janv.-11
2-juil.-10
2-sept.-10
2-mai-10
1.10
Figure 5. 2Y geometric Asian option with monthly returns. Here the vega is
decomposed over a continuous density of options in strike and in time.
and BS (T, K|S) the Black-Scholes Gamma for a strike K, a maturity T and a spot S. From the
closed-form expression for the Gamma in the Black-Scholes model, the integration over S1 in the
A MONTE-CARLO APPROACH
11
200%-300%
200%-300%
100%-200%
100%-200%
300%
200%
0%-100%
0%-100%
200%
-100%-0%
-100%-0%
100%
-200%-100%
-300%-200%
100%
-200%--100%
-300%--200%
0%
0%
-100%
-100%
-200%
-200%
1.9
1.5
1.8
-300%
0.3
2-mars-12
2-nov.-11
2-janv.-12
2-mai-11
2-juil.-11
0.7
2-sept.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
1.1
2-mai-10
2-nov.-11
2-janv.-12
0.3
2-mars-12
2-mai-11
2-juil.-11
2-sept.-11
2-nov.-10
2-janv.-11
0.8
2-mars-11
2-mai-10
2-juil.-10
2-sept.-10
-300%
2-juil.-10
1.3
Ratio
300%
European 2Y
American 2Y
200%
100%
0%
0.3
0.5
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
-100%
-200%
-300%
Figure 7. Ratio between the Vega weights for the European and American digital
options. For a replication argument in the Black-Scholes framework, we expect a
ratio 2 [4]. Here we see a ratio 2.15.
loc (T, K)
1
q
K 2 2 2
BS
Q
t2 T + t1 1
t1
T
e
(t T )
(1 tt1 ) ln SK0 ln Q BS 22
t
2 2 (t2 T +t1 (1 1 ))
BS
T
!2
1T [t1 ,t2 ]
`
PIERRE HENRY-LABORDERE
12
2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12
Vega Weight
25%
20%
15%
10%
5%
0%
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
-5%
+
S1 S2
Figure 8. At-the-money Call on Max: max( ST1 , ST2 ) 1
with T = 2Y. 1,2 =
0
20%, = 50%.
2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12
Vega Weight
8%
7%
6%
5%
4%
3%
2%
1%
0%
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
-1%
1
2
1
ST
S01
2
ST
S02
+
, with T =
A MONTE-CARLO APPROACH
13
20%
15%-20%
10%-15%
5%-10%
15%
10%
0%-5%
5%
-5%-0%
-10%--5%
0%
-5%
1.90
1.50
-10%
2-janv.-12
0.30
2-mars-12
2-sept.-11
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
2-mai-10
2-juil.-10
1.10
St2
St1
+
, with t1 = 1Y and
Form this expression and Theorem 2.4, we deduce the weights BS (T, K). In particular at t1 and
t2 , we get
ln Q+
(10)
(11)
BS (t1 , K)
BS (t2 , K)
1
Q
p
e
2 (t t )
K 2 2BS
2
1
Q
1
q
K 2 2 2 t (1
BS 1
2 (t t )
BS
2
1
2
!2
2 2 (t2 t1 )
BS
t1
t2 )
and a continuous density of options for intermediate maturities (t1 , t2 ). Equation (10) indicates
that the vega hedge at t1 corresponds to hold a strip of call options with a weight proportional
S
to 1/K 2 for a strike K. This can be synthesized by holding a log-contract with payoff ln St01 . We
have checked our analytical expression for the weights against our numerical algorithm (see Figs
10, 11). .
Conclusion
In this paper, we have designed an efficient algorithm to hedge the volatility sensitivity according
to a (local) deformation of the local volatility. A slight extension in the case of Libor Market
Models has been outlined.
`
PIERRE HENRY-LABORDERE
14
5%
4%-5%
3%-4%
2%-3%
4%
3%
1%-2%
0%-1%
-1%-0%
-2%--1%
2%
1%
0%
-3%--2%
-1%
-4%--3%
-2%
1.90
1.50
-3%
-4%
2-janv.-12
0.30
2-mars-12
2-sept.-11
2-nov.-11
2-mai-11
0.70
2-juil.-11
2-janv.-11
2-mars-11
2-sept.-10
2-nov.-10
2-mai-10
2-juil.-10
1.10
St2
St1
0.95
+
St2
St1
1.05
+
Acknowledgements
The author would like to thank his colleagues, in particular L. Bergomi and P. Carpentier for
fruitful discussions.
6. Appendix: Proofs
Proof Proposition 2.3. We set the proof in d = 1. The multi-dimensional case follows exactly the
O( 2 + ()2 )) satisfies the PDE
same arguments. O() (resp. O
1
t O + S 2 2 (t, S)S2 O = 0
2
+ 1 S 2 ((t, S) + ()(t, S))2 S2 O
=0
t O
2
(12)
(13)
By subtracting these two PDEs, we can formally apply the Feynman-Kac formula and get
O
O
Z
=
0
tn
Z tn h
h
i
i
s ds + 1 2
s ds
E0 (s, Ss )(s, Ss )Ss2 S2 s O
E0 ((s, Ss ))2 Ss2 S2 s O
2
0
A MONTE-CARLO APPROACH
15
This representation follows from the uniqueness of weak solution of (12), (13) due to the uniform
ellipticity assumption (see [5] for details). By iterating this equation, we get
Z tn
h
i
O
O
dsE0 (s, Ss )(s, Ss )Ss2 S2 s Os ds
=
0
Z u
Z tn
h
i
u ()2 (s, Ss )S 2 2 Os ds
dsE0 ()2 (u, Su )Su2 S2 u O
du
+
s Ss
0
0
Z tn h
i
1 2
s ds
+
E0 ((s, Ss ))2 Ss2 S2 s O
2
0
By using Gaussian estimates for the fundamental solutions p (resp. p) of (12) (resp. (13)), (x, y =
ln S)
C
(x y)2
xk p(t, x|u, y)
exp
c
|t u|
|t u|(1+k)/2
one can show that the second and third terms goes to 0 when 0 (see Proposition 2.1 in [3]).
The key argument is that the constants c and C depends only on the uniform elliptic constant (not
on ), appearing in Assump 1. The Gateaux derivative is therefore
Z tn
h
i
O =
dsE0 (s, Ss )(s, Ss )Ss2 S2 s Os ds
0
tn
dT
0
h
i
2
dK(T, K)E0 K
OT |ST = K 1tn T
By applying the Green operator LT K on both sides of the equation above, we get our final result
(4).
Proof Proposition 3.2. We deform locally the LV by
dSt = (t, St )dWt , S0 = S0
where (t, S) = (t, S) + (t, S) and the initial condition S0 = S0 . Here for ease of the presentation, (t, S) denotes a normal LV. Then, the process Zt = St satisfies the SDE
(16)
with the initial condition Z0 = 0. Similarly, the tangent process Yt = S0 St satisfies the SDE
dYt = S (t, St )Yt dWt
`
PIERRE HENRY-LABORDERE
16
with the initial condition Y0 = 1. Using Itos lemma, the solution of (16) is
Z t
Z t
1
1
(17)
(s, Ss )(s, Ss )ds +
(s, Ss )dWs Yt
Zt =
S
0 Ys
0 Ys
The payoff sensitivity with respect to (i.e. local Vega) is
n
h
i
X
O |=0 =
(18)
E0 i Zt0i
i=1
(19)
Zt0i ,
n
X
we obtain
E0 i Yti Zt0i
i=1
Using the Malliavin integration by part formula, the Vega can be represented as (see Proposition
3.3 in [9])
h
i
(20)
E0 ()
with
() =
n
X
(Zt0j Zt0j1 )
j=1
tj
tj1
Ys a(s)
dWs
(s, Ss )
tj
tj1
!
Ys a(s)
(Ds Zt0j Ds Zt0j1 )ds
(s, Ss )
Z
() denotes the Skorokhod integral of and Zt0 Y t0 . The function a() is such that
t
Z tj
a(s)ds = 1 , j = 1, . . . , n
tj1
Note that the Skorohod integral involves an infinite number of processes parameterized by s:
{Ds Zt0 }s[0,T ] . We explain how to reduce the complexity of this equation below.
We recall that
dZt0 =
(t, St )
(S (t, St )dt + dWt ) , Z00 = 0
Yt
=
Ys
Yt2
(s, Ss )
(t, St )S2 (t, St )
dt
Ys
(S (t, St )dt + dWt )
s)
with the initial condition Ds Zs0 = (s,S
Ys . A straightforward computation shows that Ds Yt can be
written as
(s, Ss )
s
(s, Ss )
Ds Yt =
Ys S ln (s, Ss )
Yt +
t
Ys
Ys
Ys
with
dt
S2 (t, St )(s, Ss )
Yt2
dWt + S (t, St )t dWt
Bs Ys
D s Zt =
t s S (s, Ss )
Zt Zs +
1t>s
Ys
Ys2
Ys
A MONTE-CARLO APPROACH
17
with
d1t
=
(2)
We note t
(t, St )t
(S (t, St )dt + dWt ) + (S ((t, St )S (t, St )) dt + S (t, St )dWt )
Yt2
t
Yt
Proof Proposition 3.1 (see [1] for a close computation). We have seen in the previous proof that
the payoff sensitivity with respect to is (see Equation 18)
O |=0
n
X
i
h
E0 i Zt0i
i=1
n
X
i=1
Z
h
E0 i Yti
ti
1
S (s, Ss )(s, Ss )ds +
Ys
=
=
Z
0
ti
i
1
(s, Ss )dWs
Ys
h
i
1
E0 i Yti ( (, S ))
Y
h Z tn
i
1
E0
Ds (i Yti ) (s, Ss )ds
Ys
0
In the first line, we have used that the Skorokhod integral of an adapted process coincides with the
It
o integral. In the second line, we have applied the Malliavin integration by part formula. With
the notations in the proof of Proposition 3.2, we get
n
h Z tn (s, S )(s, S )
i
X
s
s
(2)
(2)
O |=0 =
E0
Y
(
)ds
i
t
t
s
i
i
Ys2
0
i=1
Z tn
n
i
h
X
Yt
+
E0 Yti ij
(s, Ss ) 2j (s, Ss )ds
Ys
0
i,j=1
Taking (s, Ss ) = K(sT )(Ss K) and replacing (s, S) by (s, S)S, we get our final result.
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18
`
PIERRE HENRY-LABORDERE
te
Ge
ne
rale, Quantitative Research Global Markets, GEDS
Socie
E-mail address: pierre.henry-labordere@sgcib.com