Skew Hedging

Skew Hedging
Szymon Borak
Matthias R. Fengler
Wolfgang K. Hardle
CASE-Center for Applied
Statistics and Economics
Humboldt-Universitat zu Berlin
Motivation
1-1
Barrier options
100
asset price
Knock-out options are financial options that become worthless as

soon as the underlying reaches a prespecified barrier.
Figure 1: Example of two possible paths of assets price. When the

price hits the barrier (red) the option is no longer valid regardless
further evolution of the price.
2 infuence on the IVS
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-2
Barrier options
In BS world prices of barrier options are given analytically, all

greeks can be calculated directly.
The price doesnt need to be a increasing function of the
volatility parameter .
Marking to BS model is precluded due to the choice
BS is not a good choice for handling barrier options!!!

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
up-and-out
10.3
price
10
9.7
10.1
9.8
10.2
9.9
price
10
10.4
10.1
10.5
10.2
down-and-out
0.1
0.2
BS sigma
0.3
0.4
0.1
0.2
BS sigma
0.3
0.4
Figure 2: Price of the call knock-out barrier options as a function of

BS-. Asset value S0 = 90, strike price K = 80 time to maturity
= 0.1 interest rate r = 0.03. Left panel: barrier B = 80. Right
panel: barrier B = 120.
Motivation
1-4
Pricing Barrier Options
For pricing barrier options a local volatility (LV) model is

employed. The asset price dynamics are governed by the stochastic
differential equation:
dSt
= dt + (St , t)dWt
St
(1)
where Wt is a Brownian motion, the drift and (St , t) the local

volatility function which depends on the asset price and time only.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-5
Pricing Barrier Options
Price depends on the entire implied volatility surface (IVS). From

the IVS one can calculate Ct (K , T ).
Dupire formula:
2 (K , t) = 2
Ct (K ,T )
(K ,T )
+ rK CtK
T
2
t (K ,T )
K 2 CK
2
gives the LV surface (St , t). For practical implementation see

Andersen and Brotherthon-Ratcliffe (1997).

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-6
Dynamics of the IVS

The IVS reveals highly dynamic behavior, which influences the
prices of the barrier options.
Example
Consider two one year knock-out put options with strike 110 and
barrier 80, when the current spot level is 100. Take the IVS from
20000103 and 20010102. The prices of these options are
respectively 1.91 and 2.37. This is a 25% difference.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-7
smile on different days

0.5
20000103
20010102
0.45
implied volatility
0.4
0.35
0.3
0.25
0.2
0.7
0.8
0.9
1
1.1
moneyness
1.2
1.3
1.4
1.5
Figure 3: Observed smile on 20000103 and 20010102 for the maturity

0.25.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-8
Vega Hedging
In LV model the usual vega cannot be used because the whole

IVS is an input
The standard approach is to build vega hedging on the
sensitivity of the up-and-down shifts.
The skew changes, which may cause significant pricing
differences, become unhedged.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-9
DSFM
A complex dynamics of the IVS is explained in terms of a dynamic

semiparametric factor model (DSFM) for the (log)-IVS
Yi,j (i = day, j = intraday):
Yi,j = m0 (Xi,j ) +
L
X
i,l ml (Xi,j ) + i,j .
(2)
l=1
Here ml (Xi,j ) are smooth factor functions and i,l is a multivariate

(loading) time-series.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-10
Aims
to apply DSFM for identification of key factors of the IVS

dynamics
to improve the vega hedge by hedging against most common
changes of the IVS

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Motivation
1-11
Overview
1. MotivationX
2. Dynamic Semiparametric Factor Model
3. Hedging Approach
4. Results
5. Conclusion

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
DSFM
2-1
DSFM
Consider DSFM for the log-IVS:
Yi,j = m0 (Xi,j ) +
L
X
i,l ml (Xi,j ) + i,j ,
(3)
l=1
Yi,j is log IV,i denotes the trading day (i = 1, . . . , I ),

j = 1, . . . , Ji is an index of the traded options on day i.
ml () for l = 0, . . . , L are basis functions in covariables Xi,j
(moneyness, time to maturity),
and i are time dependent factors.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
DSFM
2-2
DSFM estimation
def
b l and bi,l with bi,0 = 1, as minimizers of:
Define estimates of m
Ji Z
I X
X
i=1 j=1
(
Yi,j
L
X
)2
b l (u)
bi,l m
Kh (u Xi,j ) du,
(4)
l=0
where Kh denotes a two dimensional product kernel,

Kh (u) = kh1 (u1 ) kh2 (u2 ), h = (h1 , h2 ) with a one-dimensional
kernel kh (v ) = h1 k(h1 v ).
See Fengler et al. (2005), Fengler (2005).

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
results
3-1
Model parameters
We fit our model:

L = 3 dynamic basis functions
grid covering moneyness [0.6, 1.3] and time to maturity
[0.05, 1]
fix bandwidths in moneyness direction and increasing
bandwidths in maturity direction
on the daily IVS data from 20000103 till 20011220

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
mhat1
mhat0
0.6
0.4
0.5
0.2
1
0
0.2
1.5
0.4
2
1.5
0.6
1.5
1
0.8
0.8
0.6
0.6
0.4
0.4
moneyness
0.5
0.2
0
moneyness
maturity
0.5
0.2
0
maturity
b 0 and dynamic basis function m

b1
Figure 4: Invariant basis function m
(level)
mhat3
mhat2
2
1
0
0.8
2
1.4
4
1.5
0.6
0.4
1.2
1
0.6
0.4
0.2
0.8
0.6
moneyness
1
0.8
0.4
maturity
moneyness
0.5
0.2
0
maturity
b 2 (skew) and m
b 3 (term strucFigure 5: Dynamic basis functions m
ture)
1
1.5
1
0.5
0
Jan00
Jan01
Jan02
Jan03
Jan04
Jan05
Jan03
Jan04
Jan05
ATM
0
0.2
0.4
0.6
0.8
Jan00
Jan01
Jan02
Figure 6: time series of weights b1 and ATM IVS for the fixed maturity 0.25.
2
0.2
0.1
0
0.1
0.2
Jan00
Jan01
Jan02
Jan03
Jan04
Jan05
Jan03
Jan04
Jan05
3
0.2
0.1
0
0.1
0.2
Jan00
Jan01
Jan02
Figure 7: Time series of weights b2 and b3

0.34
0.32
implied volatility
0.3
0.28
0.26
0.24
0.22
0.2
0.18
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Figure 8: Typical shape of the smile for different levels of b1 .

Changes of the b1 influence mainly the surfaces level.

0.36
0.34
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Figure 9: Typical shape of the smile for different levels of b2 .

Changes of the b2 influence the smiles skew.
hedging
4-1
Greeks
In order to implement -hedging one has to calculate

-greeks.
b direction.
They are obtained by shifting the IVS in the m
b
b
option
option(IVSe m
) option(IVSe m
)
b
2b
b
(5)

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
vega
4
2
0
2
4
6
8
10
12
14
3000
4000
5000
6000
7000
spot
8000
9000
10000
11000
Figure 10: vega greek for down-and-out put option with barrier
5400 and strike 7425 as a function of spot
1
6
1
3000
4000
5000
6000
7000
spot
8000
9000
10000
11000
Figure 11: b1 greek for down-and-out put option with barrier 5400
and strike 7425 as a function of spot
2
2.5
2
1.5
1
0.5
0
0.5
1
1.5
2
2.5
3000
4000
5000
6000
7000
spot
8000
9000
10000
11000
Figure 12: b2 greek for down-and-out put option with barrier 5400
and strike 7425 as a function of spot
hedging
4-5
Example
In the BS model the hedge portfolio (HP) for hedging plain vanilla
options consists of a stocks - HP = aS. The hedge ratio a (delta)
is obtained from:
dHP
option
=a=
.
dS
S
The hedge is financed by buying/selling bonds.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
hedging
4-6
How to compute the hedge ratios

Take two hedge portfolios HP1 and HP2 .
Compute the sensitivities of the hedge portfolios and the
up-and-out call option (C KO ) with respect to b1 and b2 .
Solve
HP1
b1
HP1
b2
HP2
b1
HP2
b2
a1
a2
C KO
b1
C KO
b2
vega
skew
for the hedge ratios a1 , a2 . For the down-and-out put option

(P KO ) the procedure is analogous.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
hedging
4-7
Choice of the hedge portfolio

Idea:
choose HP1 and HP2 with maximum exposure to b1 and b2 ,
respectively:
HP1 should be most sensitive to up-and-down shifts:
use a portfolio of at-the-money plain vanilla options;
HP2 should be most sensitive to slope changes:
use a portfolio of vega-neutral risk reversals.
Then
HP1
b2
0 and
HP2
b1
0.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
hedging
4-8
0
-20
-10
payoff
10
Risk reversal payoff
60
80
100
asset price
120
140
Figure 13: The payoff of the risk reversal. It is composed from a

long call with strike K1 = 120 and a short put with strike K2 = 80.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
hedging
4-9
As in standard vega hedging we apply final delta hedge. In our

case we apply delta hedge to C KO + a1 HP1 + a2 HP2 by calculating
the number of underlying as:
(C KO + a1 HP1 + a2 HP2 )
S

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
downandout put
40
30
20
10
10
20
30
40
60
70
80
90
100
110
120
130
140
downandout put, long risk reversals, long ATM call

40
30
20
10
10
20
30
40
60
70
80
90
100
110
120
130
140
downandout put, long risk reversals, long ATM call, short spot
40
30
20
10
10
20
30
40
60
70
80
90
100
110
120
130
140
results
5-1
Empirical Study
For each of 885 days (20000103-20030707) we start one long
position in one year C KO and P KO .
Option
C KO
P KO
barrier
140 %
80 %
strike
80 %
110 %
maturity
1 year
1 year
knock-outs
10 %
81 %
in-the-money
39 %
5%
Table 1: barrier and strike are given as a percentage of the spot at

the starting day
We keep the position until maturity or knock-out.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
results
5-2
Empirical Study
We compare the b1 b2 (skew) hedging approach with:

b1 hedging - no risk reversal (a2 = 0) and a1 =
C KO HP1
/ b
b1
1
vega hedging - no risk reversal (a2 = 0) and a1 =
C KO HP1
/

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
results
5-3
Aims of Hedging
We define the profit and loss of the strategy at the maturity

as a portfolios value divided by notional at the starting day.
CTKO + HPT + moneyT
S0
The aim of the hedging is possibly large reduction of the
profit and loss variation around zero.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
results
5-4
Results
Profit and loss of the strategy at the maturity.
C KO
min
max
mean
median
std
med. abs.
vega
1
1 2
-0.1038
-0.0752
-0.0830
0.5813
0.5768
0.5684
-0.0165
-0.0118
-0.0066
-0.0175
-0.0136
-0.0119
0.0209
0.0183
0.0137
0.0413
0.0387
0.0345
Table 2: all values as percentage of the underlying

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
C KO
days
min
max
mean
median
std
med. abs.
vega
0
1
10
25
0
1
10
25
0
1
10
25
-0.1038
-0.1038
-0.0833
-0.0797
-0.0752
-0.0751
-0.0766
-0.0731
-0.0830
-0.0829
-0.0375
-0.0360
0.5813
0.1710
0.0710
0.0590
0.5768
0.1459
0.0702
0.0508
0.5684
0.1220
0.0831
0.0499
-0.0165
-0.0186
-0.0184
-0.0191
-0.0118
-0.0139
-0.0143
-0.0150
-0.0066
-0.0088
-0.0095
-0.0104
-0.0175
-0.0171
-0.0164
-0.0151
-0.0136
-0.0130
-0.0130
-0.0116
-0.0119
-0.0120
-0.0119
-0.0123
0.0209
0.0183
0.0172
0.0150
0.0183
0.0157
0.0154
0.0130
0.0137
0.0112
0.0106
0.0082
0.0413
0.0276
0.0241
0.0207
0.0387
0.0240
0.0210
0.0175
0.0345
0.0184
0.0149
0.0114
1 2
Table 3: Descriptive statistics for the hedging strategies 0, 1, 10 and

25 days before the knock-out or expiration - delta hedging effect
(gap risk).
results
5-6
Results
Profit and loss of the strategy at the maturity.
P KO
min
max
mean
median
std
med. abs.
vega
1
1 2
-0.0264
-0.0210
-0.0332
0.2799
0.2808
0.2676
0.0058
0.0080
0.0065
-0.0004
0.0016
0.0008
0.0105
0.0107
0.0092
0.0213
0.0214
0.0196
Table 4: Descriptive statistics for the hedging strategies of the downand-out put

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
P KO
days
min
max
mean
median
std
med. abs.
vega
0
1
10
25
0
1
10
25
0
1
10
25
-0.0264
-0.0209
-0.0161
-0.0142
-0.0210
-0.0157
-0.0106
-0.0109
-0.0332
-0.0249
-0.0110
-0.0092
0.2799
0.0344
0.0231
0.0189
0.2808
0.0350
0.0276
0.0202
0.2676
0.0270
0.0200
0.0200
0.0058
-0.0040
-0.0024
-0.0018
0.0080
-0.0017
-0.0002
-0.0001
0.0065
-0.0032
-0.0017
-0.0011
-0.0004
-0.0048
-0.0027
-0.0014
0.0016
-0.0030
-0.0009
-0.0002
0.0008
-0.0032
-0.0016
-0.0007
0.0105
0.0042
0.0037
0.0033
0.0107
0.0038
0.0031
0.0027
0.0092
0.0030
0.0027
0.0023
0.0213
0.0064
0.0056
0.0046
0.0214
0.0060
0.0053
0.0041
0.0196
0.0044
0.0038
0.0034
1 2
Table 5: Descriptive statistics for the hedging strategies 0, 1, 10 and

25 days before the knock-out or expiration - delta hedging effect
(gap risk).
results
5-8
std. of the hedge portfolios in time (up and out call)
0.045
vega
1
std. of Cumlative HedgingError / Notional
0.04
1 2
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
50
100
150
days to expiry
200
250
Figure 14: The standard deviation of the portfolios as a function of

the days left to the maturity (call).
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
results
5-9
std. of the hedge portfolios in time (down and out put)
0.025
std. of Cumlative HedgingError / Notional
vega
1
1 2
0.02
0.015
0.01
0.005
50
100
150
days to expiry
200
250
Figure 15: The standard deviation of the portfolios as a function of

the days left to the maturity (put).
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
conclusion
6-1
Conclusion
the hedge improves the hedging
gap risk is still unhedged.
better strategy might be to mix static and dynamic hedges

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
bibliography
7-1
Reference
Andersen L. and Brotherton-Ratcliffe R.
The equity option volatility smile: An implicit finite difference
approach
Journal of Computational Finance 1(2) 5-37, 1997.
Borak, S., Fengler, M. and Hardle, W.
DSFM fitting of Implied Volatilty Surfaces
Conference proceedings of the Fifth International Conference
on Intelligent Systems Design and Applications, 2005.
Dupire, B.
Pricing with a smile,
RISK , 7(1):1820, 1994.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
bibliography
7-2
Reference
Fengler, M.
Semiparametric Modelling of Implied Volatility
Heildelberg: Springer Verlag, 2005
Fengler, M.
Arbitrage-free smoothing of the implied volatility surface
SFB 649 Discussion Paper, 2005.
Fengler, M., Hardle, W. and Mammen, E.
A Dynamic Semiparametric Factor Model for Implied Volatility
String Dynamics
SFB 649 Discussion Paper, 2005.
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
delta * mean(|dS|)
150
PL contribution
100
50
50
1
0.8
12000
0.6
10000
8000
0.4
6000
0.2
maturity
4000
0
2000
spot
Figure 16: Profit-and-loss contribution of the delta for down-and-out

put option with barrier 5400 and strike 7425. The mean value of
= 66.01.
absolute underlying changes |dS|
theta
25
PL contribution
20
15
10
5
0
5
1
0.8
12000
0.6
10000
8000
0.4
6000
0.2
maturity
4000
0
2000
spot
Figure 17: Profit-and-loss contribution of the theta for down-and-out

put option with barrier 5400 and strike 7425.
vega*mean(|d|)
PL contribution
0
5
10
15
20
1
0.8
12000
0.6
10000
8000
0.4
6000
0.2
maturity
4000
0
2000
spot
Figure 18: Profit-and-loss contribution of the vega for down-and-out

put option with barrier 5400 and strike 7425. is taken as at-themoney IV for maturity 0.25. The mean value of absolute changes
= 0.67 in vol. points.
|d|
beta1*mean(|d1|)
30
25
PL contribution
20
15
10
5
0
5
10
1
0.8
12000
0.6
10000
8000
0.4
6000
0.2
maturity
4000
0
2000
spot
Figure 19: Profit-and-loss contribution of the 1 for down-and-out

beta2 * mean(|d2|)
PL contribution
1
0
1
2
3
4
5
1
0.8
12000
0.6
10000
8000
0.4
6000
0.2
maturity
4000
0
2000
spot
Figure 20: Profit-and-loss contribution of the 2 for down-and-out

Appendix
8-6
in the money
0.25
PL contribution / price of the option
0.2
delta
vega
0.15
beta1
theta
beta2
0.1
0.05
0.05
0.1
0.1
0.2
0.3
0.4
0.5
maturity
0.6
0.7
0.8
0.9
Figure 21: Profit-and-loss contribution divided by down-and-out put

price for ITM option.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Appendix
8-7
at the money
0.04
0.02
0
0.02
0.04
0.06
delta
vega
0.08
beta1
theta
beta2
0.1
0.12
0.14
0.1
0.2
0.3
0.4
0.5
maturity
0.6
0.7
0.8
0.9

price for ATM option.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Appendix
8-8
out of the money

0.1
0.05
0.05
0.1
delta
vega
beta1
theta
beta2
0.15
0.2
0.25
0.1
0.2
0.3
0.4
0.5
maturity
0.6
0.7
0.8
0.9

price for OTM option.

0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3
Appendix
8-9
delta
0.5
0.4
0.3
0.2
0.1
0.1
0.2
3000
4000
5000
6000
7000
spot
8000
9000
10000
11000
Figure 24: Delta as a function of the spot for the half year downand-out put option with strike price 7425 and barrier 5400
0.36
0.34
Skew Hedging
implied volatility
0.32
0.3
0.28
0.26
0.24
0.22
0.6
0.7
0.8
0.9
1
moneyness
1.1
1.2
1.3

Skew Hedging

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Skew Hedging

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Skew Hedging

Knock-out options are financial options that become worthless as

Figure 1: Example of two possible paths of assets price. When the

In BS world prices of barrier options are given analytically, all

2 infuence on the IVS

Figure 2: Price of the call knock-out barrier options as a function of

Pricing Barrier Options

For pricing barrier options a local volatility (LV) model is

where Wt is a Brownian motion, the drift and (St , t) the local

2 infuence on the IVS

Pricing Barrier Options

Price depends on the entire implied volatility surface (IVS). From

gives the LV surface (St , t). For practical implementation see

2 infuence on the IVS

Dynamics of the IVS

smile on different days

Figure 3: Observed smile on 20000103 and 20010102 for the maturity

In LV model the usual vega cannot be used because the whole

2 infuence on the IVS

A complex dynamics of the IVS is explained in terms of a dynamic

i,l ml (Xi,j ) + i,j .

Here ml (Xi,j ) are smooth factor functions and i,l is a multivariate

2 infuence on the IVS

to apply DSFM for identification of key factors of the IVS

2 infuence on the IVS

2 infuence on the IVS

i,l ml (Xi,j ) + i,j ,

Yi,j is log IV,i denotes the trading day (i = 1, . . . , I ),

where Kh denotes a two dimensional product kernel,

2 infuence on the IVS

We fit our model:

2 infuence on the IVS

b 0 and dynamic basis function m

Figure 7: Time series of weights b2 and b3

1 infuence on the IVS

Figure 8: Typical shape of the smile for different levels of b1 .

2 infuence on the IVS

Figure 9: Typical shape of the smile for different levels of b2 .

In order to implement -hedging one has to calculate

2 infuence on the IVS

2 infuence on the IVS

How to compute the hedge ratios

for the hedge ratios a1 , a2 . For the down-and-out put option

Choice of the hedge portfolio

2 infuence on the IVS

Risk reversal payoff

Figure 13: The payoff of the risk reversal. It is composed from a

As in standard vega hedging we apply final delta hedge. In our

2 infuence on the IVS

downandout put, long risk reversals, long ATM call

Table 1: barrier and strike are given as a percentage of the spot at

We compare the b1 b2 (skew) hedging approach with:

vega hedging - no risk reversal (a2 = 0) and a1 =

2 infuence on the IVS

We define the profit and loss of the strategy at the maturity

2 infuence on the IVS

Table 2: all values as percentage of the underlying

2 infuence on the IVS

Table 3: Descriptive statistics for the hedging strategies 0, 1, 10 and

2 infuence on the IVS

Table 5: Descriptive statistics for the hedging strategies 0, 1, 10 and

std. of Cumlative HedgingError / Notional

Figure 14: The standard deviation of the portfolios as a function of

std. of Cumlative HedgingError / Notional