Building a Good Implied Volatility Surface and a Robust Local Volatility Model

Bruno Dupire Bloomberg L.P.

Sao Paulo, December 1, 2008

1) Building a Good Implied Volatility Surface

Uses of the Surface

Implied volatility surface is the central object for derivatives, as yield curve is for fixed income Gives prices of vanillas of all strikes and maturities Gives variance swaps term structure Gives forward and local volatilities Constrains the price of exotics Identifies cheap/expensive strikes and maturities

Aug 07 Sept 07 Oct 07 Dec 07

Mar 08

Jun 08

Dec 08

Mar 09

S&P Strikes and Maturities

Jun 09

S&P 500

Wish List
A good implied volatility surface should be Accurate Smooth Arbitrage free Robust to missing data

What NOT to do
Interpolate prices Extrapolate volatilities with 0, flat or linear Create inter/intra maturity arbitrage

Price Interpolation

Listed Implied Volatilities

The first step is to get implied volatilities of listed options Synchronicity Implied forward/dividends DeAmericanization: EEP is model dependent

Issues with Stocks

Less option data American prices - DeAmericanization: 1 by 1 vs global Discrete dividends create discontinuities in implied volatilities Event calendar can be inserted

Event Calendar

What is Usually Done

Common market practice: 1) fit each market maturity with a few parameters (typically 4 or 5) 2) interpolate between maturities

The Meaning of Interpolation

To interpolate is to guess To extrapolate is even more so Stabilize the known data - easier with volatilities than prices - still strong skew - other models may normalize further

The Plan
Chose a good fitting model Compute residuals (market model) Interpolate the residuals Add them back

The Logic
1) Fit of parametric model on all data - Parametric => robust gap filling - Model => arbitrage free 2) Non parametric fine tuning => accurate Both 1) and 2) are infinitely smooth

Heston Model
Dynamics
dSt = (r q )dt + vt dWt St dvt = ( vt )dt + vt dBt dBt dWt = dt

Impact of VolVol

Impact of Mean Reversion

Impact of Correlation

Impact of Everything

Heston Computation
FFT: fractional/decay Integration Control variate Analytical asymptote

Heston Fit to S&P500

Residual Fitting
Non parametric interpolation Decaying extrapolation to inherit arbitrage free asymptotes

S&P 500 Residuals

S&P 500 Residuals

S&P 500 Fit

Cumulative variance as a function of strike. One curve per maturity. Dotted line: Heston, Red line: Heston + residuals, bubbles: market

RMS in bps BS: 305 Heston: 47 H+residuals: 7

S&P 500 implied volatility

2) Exploiting the Surface

S&P 500 RN Densities

S&P 500/Euro Stoxx 6m RN Densities

S&P 500/NASDAQ 6m RN Densities

Variance Swaps
Variance swap replicated by Log profile, which requires all strikes. Issues: Discrete strikes Impact of jumps Stochastic interest rates

Cheap/rich analysis
Residuals trading

3) Building LVM

Local Volatility Model

Simplest model to fit a full surface Forward volatilities that can be locked

dS = ( r d ) dt + ( S , t ) dW S C 2 (K , T ) 2 2C C = K (r d )K d C 2 T 2 K K

Summary of LVM
Simplest model that fits vanillas Second most used model (after Black-Scholes) in Equity Derivatives Local volatilities: forward vols that can be locked by a vanilla PF Stoch vol model calibrated
2 E[ t2 St = S ] = loc ( S , t )

If no jumps, deterministic implied vols => LVM

S&P500 implied and local vol

Exotic Pricing : OVME

Volatility Expansion
X : exotic option and : local variances functions

X ( + ) = X () + m( S , t ) ( S , t ) dS dt
S2 E tX | St = S + ( S , t ) is the sensitivity where m(S,t) = 2 of X to the local volatility at (S,t) (Frechet derivative).

One Touch Option - Price

Black-Scholes model S0=100, H=110, =0.25, T=0.25

One Touch Option -

1 O.T . : m( S , t ) = . .P.S 2 2

Up-Out Call - Price

Black-Scholes model S0=100, H=110, K=90, =0.25, T=0.25

Up-Out Call -

1 UOC : m( S , t ) = . .P.S 2 2

Vanilla hedging portfolios

S2 E tX | S t = S + ( S , t ) is the sensitivity of X Recall m( S , t ) = 2 to the local volatility at (S,t). Portfolio PF = ( K , T ) C K ,T dK dT of vanillas hedges all small volatility moves Solved by : 2 (K ,T ) 2 h( K , T ) 2 h( K , T ) + ( K , T ) = t S 2 (S,t), PF ( S , t ) = E tX | St = S = h( S , t )

Link /Vega

Conclusion
Parametric fit for robustness Non parametric interpolation for accuracy Implied volatility surface is central to many uses Local volatilities are the important first step for exotic pricing and risk management

Quantitative Corner