6 A Unified Theory of Volatility Bruno Dupire Bloomberg Modern finance can be seen as the art of establishing links between liquid and illiquid assets. For a long time pricing has consisted of assessing the fair value of let us say, a stock, from some information such as a balance sheet or economic fundamen- tals. The advent of options displaced this focus by establishing a link between the stock Price, taken as given, and the option price. This has been rendered Possible thanks to the Black-Scholes- Merton model which reduced the problem to merely one of volatil- ity estimation. We now have to make a further step forward. The proliferation of more complex options, whether it be in variety or volume, has Spurred the necessity of. establishing a third link, between European options and exotic options. European options prices are taken as given and a model has to be developed which respects those prices and exhibits a reasonable degree of plausibility. Respecting European option prices is feasible with a simple extension of Black-Scholes, which considers local volatilities as a deterministic function of time and spot level. This model has the considerable merit of preserving the main features of Black- Scholes model (only one Brownian Motion, theoretical ability to hedge any exotic with the asset itself). It even seems to emerge as the compulsory benchmark model to price exotics consistently with Europeans. Unfortunately, it has the considerable drawback Of assuming that the local volatilities computed today will be ae 185DERIVATIVES PRICING: THE CLASSIC COLLECTION 186 realised with certainty in the future. In that respect it lacks plau- sibility, as the real world is not amenable to such simplicity and tends to bewilder us with the unexpected. What is mentioned here as unified is a model which combines two essential features: first, compatibility with European option prices, second random local volatilities. The derivation is along the lines of Dupire (1992). It parallels the logic of Heath-Jarrow-Morton, transposing to volatility the analysis which they conducted on interest rates. We start by extracting some instantaneous forward volatilities (thus ensuring compatibility with current implied volatilities), then we make some assumptions about their evolution and finally obtain the risk neutral dynamics of the current instan- taneous volatility, which is exactly what is needed to price and hedge contingent claims. In the second section, we show how to synthesise instantaneous forward variances conditional to spot values, make assumptions on their dynamics and obtain the risk neutral process of the instan- taneous volatility in the third section. The fourth section makes use of the Martingale Representation Theorem to price contingent claims and the fifth section addresses hedging issues. Applications are considered in the sixth section, extensions investigated in the seventh section and conclusions presented in the eighth section. PRIME: MARKET EVIDENCE Market smiles Market participants have unanimously adhered to the Black-Scholes model since its unveiling in 1973. In the Black-Scholes model, the stock follows a geometric Brownian motion. ds S=pdt+odw S and generates option Prices as a function of the volatility ¢, assumed tobe constant. This relationship can be inverted, which allows one to infer for any option the only volatility input compatible with its mar- ket price. Its called the implied volatility. Were the Black-Scholes model a perfect description of real price moves, all implied volatilities would be equal across all strikes and maturities. In recent years, markets have e been displaying volatility Patterns strongly differing from this fla noes it world.A UNIFIED THEORY OF VOLATIUTY Why smiles? Volatility smiles are more easily observed than explained. However, one can put forward tentative justifications for their presence. The most blatant one is simply demand and supply. Investors are structurally long the stock and will tend either to buy Put options (low strike) to protect the downside or to sell Call options (high strike) to enhance their returns, hence unbalancing the market. This behaviour yields to the classical downwards smile (expensive Puts, cheap Calls) that is observed on the stock market, aside from consideration of the dynamics the spot will display in the future. The crash aversion generated by October 1987 fosters deeply pronounced smiles on stock indices, which dramatically challenge Black-Scholes assumptions. It should be noted that on other markets, like Gold, a reverse pattern is experienced as an expression of sudden burn-up fears. Another stream of explanation finds its roots in the examination of spot dynamics. This means that we could in turn retrieve (or guess) them through inspection of current market prices. Examples of dynamics that produce non-flat smiles are, amongst many other possible choices, jump processes or non-constant instantaneous (will indifferently be called local) volatilities, which may either be path-dependent, deterministic function of time and spot (Dupire, 1993) or stochastic, which brings another dimension of uncertainty into the picture. A parallel, mapping local volatility to short-term interest rate and implied volatility surface to yield curve, will be conducted throughout the chapter. A most important point is that even if the current yield curve shape is mainly determined by demand and supply, arbitrage strategies enable the locking of forward parameters. Impact of smiles ; These widely differing implied volatilities substantially impact exotic (path dependent) options. Barrier options clearly illustrate this: their prices do not only depend on the implied volatility Of their European counterpart but also indeed on the likelihood of hitting the barrier, which in tum depends on what happens at any time before maturity and how the spot behaves at different levels, eeeDERIVATIVES PRICING: THE CLASSIC COLLECTION 188 WHICH MODEL? We are looking for a model which a) respects option prices, ie, fits the current implied volatility surface b) reflects the randomness of volatility, as displayed by the real world c) is complete, to ensure preference-free pricing and ability to hedge d) indeed is arbitrage-free ‘The general logic that will be followed is O compute by arbitrage from European options the Instantaneous Forward Variances (IFV) conditional to forward values of the spot OQ make a (Real World) assumption on the way the IFV’s evolve through time Q tisk neutralise these IFV dynamics Q obtain Risk Neutral dynamics of instantaneous variances O apply the Martingale Representation Theorem to price and hedge contingent claims The first point is quite thomy, requiring the use of options of differ- ent maturities and strikes and then taking limits in the right order. To lighten the analysis and make sure that the emphasis is put on the concepts and not on the notations, we assume throughout the chapter that rates are nil and dividends or repos are absent. ARBITRAGE PORTFOLIO. Ithas been shown in my previous work (Dupire, 1992) how to com- Pute the value today of a forward contract that will pay the instan- taneous variance (square of instantaneous volatility) at time T. In other terms, the contract binds the two parties to exchange at time T the realised instantaneous variance against a fixed sum which is agreed at time ty, The chapter shows the unique possible price for the fixed leg of the contract thanks to arbitrage agreements there developed. The exchange of the floating leg for the fixed leg was carried Over irrespective of the value of the Spot. As we are here interested in the Strike dimension as well, we will need a refinement of this concept, that is to say a contract that will exchange the floating leg (instantaneous Varia nce) against the fixed leg, only if the spot at T is‘A UNIFIED THEORY OF VOLATILITY around a certain value K. We will need a continuum of such con- tracts, for any value K. To set things more formally, we define Vgz a forward contract agreed at fy that will exchange at time T, v(Sz,T) against Vir(So, to) for a Dirac amount, if and only if S; = K. If Sp # K, no exchange takes place. In this chapter, we deal with absolute variance as opposed to proportional variance (in Dupire, 1992). This parallel with computing an instantancous forward rate gives us some hints on how to proceed. To compute an IFR, between T and T + 8T we lend over T + 8T and borrow over T. The transcription in option terms is a Calendar Spread: buy one Cx r+s7/ sell on Cx7- Call spread/butterfly arbitrage Asa first step in the direction of understanding the concept of IFV and how to lock it, let us try to gain some trading intuition. If we look at a portfolio comprised of a long position on Cx, 7, and a short Position on Cx 7, with T; < T, (known as a “Calendar Spread” in the market) we can compute, in a Black-Scholes world, its value at time T, as a function of S;,. We get a graph that captures the time value of Cy, 7, at Ty: Ky This Portfolio at time T, can be approximated by a simple combi- nation of Calls maturity Ty. @ (Cy-e — 2Cx + Cre) known as a “Butterfly” and whose profile is __£\__ K-e Kee Sy _-‘DERIVATIVES PRICING: THE CLASSIC COLLECTION 190 A perfect match can virtually be achieved through the use of a con- tinuum of strikes, as any profile can be decomposed as an infinite sum of Calls: J5 a(K’)Cy.pdK’. We have thus linked the two dimensions of our implied volatility surface: the maturity one (Calendar Spread) and the strike one (Butterfly). The value of the Calendar Spread at T, will depend on the then prevailing volatilities in addition to the spot S;,, as the portfolio of options maturity T, is insensitive to the volatility. We would have the ingredients to synthesise the contract V7 had the “width” of the calendar spread at T; been independent of the volatility. AN This difficulty can be turned around by the introduction of other forward contracts. We define Uk,x,,7 2S a contract that exchanges at time T the local variance u(S,T) against a fixed payment Ux, 1650 to) determined at fy if K, = S <= K (no exchange otherwise). Let us define Pary 7, contract that gives Max (Sy — K,0)? at time Tand the Parabola Calendar Spread PCS im Paar Paty y whose value at T is either 0, if S < K, or (5,1) if $ = K. Now PCSx,1 — PCS,,7 is an instrument that gives u(S,7) if and only if K, a SS K,. It appears to be the variable leg of the contract Ux,x,r which delivers o(8,1) if Ky < $< K, at T. n oe = Teg pays Ux,x,7(So,t,) if and only if K, < § < Kyand is nen actly replicated by Uk.x1 (Sorto)(Dx,r — Dx,z) where Der sa digital option, whose payoff at Tis 1 if S;= K, Ootherwise Equating the values at fy of the two legs gives Un... (Soto Dy, (Spt) — Dx,1(Soto)) = PCSx,1(So,fo) — PCSx,7(So, fo) Dividing both sides by K, - Ky and letting K; go to‘A UNIFIED THEORY OF VOLATILITY ADx.1(Sorto) _ APCSp r(Spto) 0 Vex(Sr fg) reno) = PCSe1(Sorto) aK As Vx7(So,to) is the limit as K, goes to K, of Ux,x,r (So-fo) we can tewrite the two derivatives as follows: Dg.rlSyito) _ ~PCx Sof) aK aK? and OPCSq.r(Sovto) _ a | emf) aK ~ aK aT 3 sPia ut) ” aT aK a a — 5p Cx Sorted) which after substitution in (*) gives 9 dCx (5-4) aT FC 1(Spsf0) aK? Vk.r (Soto) = Which is the local variance of the local volatility model (Dupire, 1993), Arrow Debreu Numeraire . The previous section provided a means to obtain (*) with the arbi- tage portfolio. Another way to get it is the Fokker-Planck equation (Dupire, 1993), : We present here a third and hopefully enlightening way this time in a generalised form. We fix a given (K, T) and define CS and But as: pe Cacteat TOKE a ag er’DERIVATIVES PRICING: THE CLASSIC COLLECTION and Cuneat 7 2Ck.t +}Cr-est eee eens But = lim 0 & CS and But are financial instruments, which can be valued at any time t for any spot values. Both happen to behave at time T like Dirac masses at K. More precisely, we have: C(S,T) -[78] But(S,T) Which we can read as: the price of CS expressed in terms of But at time T is: 5,7) 2 Keeping in mind that the price of an asset expressed in terms of a second one is a martingale under the measure associated with the second asset. Hence: Seu (Soy ta) = E* [CS py (Sp, T)] = EO" [He 2) Where Qk, is the martingale measure associated with But which is in tum the Arrow-Debreu security linked with (K,T). Qxr is not equivalent to Q but is a limit of martingales equivalent to Q. Re-expressing in $ terms we get: C5(S, 1) = ER [S| But(Sy, t) From the definition of CS and But we have: 2c, CStSr) = EL (6, 1) and FC, ae Buty to)= 5 192‘A UNIFIED THEORY OF VOLATIUTY On top of that, for any random variable X. rx) = E2| x Ser EX] = [x Ser] [ae =E2[X|S,=K] So taking an expectation under Qx7 is no more than taking a con- ditional expectation under Q. Combining the preceding results, we get the fundamental PDE. ac us, ay #Cer Big py a pre | MD c JE EKT Gt) 57 Soro) Ee [ > |e OK? Gorty To obtain a stochastic volatility model compatible with the market smile, we need to have: 2°EE Gf) ER*"[0(S, T)] = Vi. (Sp»f0) = se ——— For example, a lognormal model would give: By (Syrto)e ? ¥ — Sith, zh, Bile Where the denominator has to be numerically computed. REAL WORLD SDE FOR Ver Wejust saw how to extract the (Vir(So telex from the (Cx(S04))k For a given (K,T), the value of Vir computed tomorrow from the new smile surface will likely offer from the one computed today and will reflect market uncertainty regarding volatility. As Vir is a Va" ance, it must remain positive and we hence model the proportional 193DERIVATIVES 194 ICING: THE CLASSIC COLLECTION evolution of Vxr, through the SDE V; f ies) ) =< aat+ Sb, aw; Ve r(S,1) where is a drift term and the b;’s account for the sensitivity to the Brownian Motion W, affecting the whole volatility surface through- out all K’s and T's. Both « and the bs may be of very general form. For the sake of notational simplicity, we concentrate on the one Brownian Motion case. W is a Brownian motion under real world measure P. dv, 7(S, t) Ver) =adt+bdw, Under Qk, Vir is a martingale: We r(S,t) _ or Verso and under Q dV, 7(S,t) Sealer) _ 2 Ver(St) adi+bdwy where a is obtained by the change of measure from Qx1r to Q. Indeed, if we investigate the deterministic variance case (b = 0) we get for alll S, t, K, T, Var (S,t) = Ver (Sorte) Thus, 2 2Gax( Soto) Ct ee 9Cx.r(Sp, fo) ak This result was initial ly proved by double i i Fokker-Planck equation y double integration of the (see Dupire, 1992),A UNIFIED THEORY OF VOLATILITY PRICING ‘We now pay attention to a contingent claim X that will pay at time T a payoff that may depend on the full path of S (and possibly of v) and T. Once the Risk Neutral dynamics of S and v are obtained, pricing becomes almost an easy matter. We can apply the Martingale Representation Theorem to ht defined as 1(S,0,t) = E°[X;|F,] which is the expectation of the final payoff of X conditioned by the current value of the spot and of the variance at f. Indeed, hr isa Q martingale, thus we can apply the MRT which gives the existence of a and B such that ' ' MS, v,t)=I(5,,09, to) + f a, dW? +B, dW, which gives us two things: 1. The initial premium of the claim: lM(Sp,0),to)=E°%CXr|Fol 2. The hedging strategy (c.,, f,), which allows us to transform this initial premium into the final payoff. The expectation in 1 can be computed by Monte Carlo simulation or PDE methods. REFERENCES Blac, F, and M. Scholes, 1973, “The Pricing of Options and Corporate Lihiities own! Political Economy, 81, pp. 637-54. Boyle, R, 1977, “Options: A Monte Carlo Approach”, Joural of Financial Economics, Pp.323-38, Breeden, D,, and R. 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