Break Even Volatilities

Dr Bruno Dupire
Dr Arun Verma

Quantitative Research, Bloomberg LP

13th Nov, 2007 Kings College, London

 Theoretical Skew from Prices

?
=>
Problem : How to compute option prices on an underlying without
options?
For instance : compute 3 month 5% OTM Call from price history only.
1) Discounted average of the historical Intrinsic Values.
Bad : depends on bull/bear, no call/put parity.
2) Generate paths by sampling 1 day return re-centered histogram.
Problem : CLT => converges quickly to same volatility for all
strike/maturity; breaks auto-correlation and vol/spot dependency.
13th Nov, 2007 Kings College, London
 Theoretical Skew from Prices (2)
3) Discounted average of the Intrinsic Value from re-centered 3 month
histogram.
4) -Hedging : compute the implied volatility which makes the -
hedging a fair game.

13th Nov, 2007 Kings College, London

 Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history?
S
Example: K
ST
3 month daily data 1

1 strike K k ST1 T1 t T2
a) price and delta hedge for a given within Black-Scholes
model
b) compute the associated final Profit & Loss: PL

c) solve for k / PL k 0
d) repeat a) b) c) for general time period and average
e) repeat a) b) c) and d) to get the theoretical Skew

13th Nov, 2007 Kings College, London

 Zero-finding of P&L

13th Nov, 2007 Kings College, London

 Strike dependency
Fair or Break-Even volatility is an average of returns,
weighted by the Gammas, which depend on the strike

13th Nov, 2007 Kings College, London

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 Alternative approaches
Shifting the returns
A simple way to ensure the forward is properly priced is to
shift all the returns,. In this case, all returns are equally
affected but the probability of each one is unchanged.
(The probabilities can be uniform or weighed to give
more importance to the recent past)

13th Nov, 2007 Kings College, London

 Alternative approaches
Entropy method
For those who have developed or acquired a taste for
equivalent measure aesthetics, it is more pleasant to
change the probabilities and not the support of the
measure, i.e. the collection of returns. This can be
achieved by an elegant and powerful method: entropy
minimization. It consists in twisting a price distribution in
a minimal way to satisfy some constraints. The initial
histogram has returns weighted with uniform
probabilities. The new one has the same support but
different probabilities.

However, this is still a global method, which applies to

the maturity returns and does not pay attention to the
sub period behavior. Remember, option pricing is made
possible thanks to dynamic replication that grinds a
global risk into a sequence of pulverized ones.
13th Nov, 2007 Kings College, London
 Alternate approaches:
Fit the best log-normal

13th Nov, 2007 Kings College, London

 Implementation details
Time windows aggregation
The most natural way to aggregate the results is to simply average
for each strike over the time windows. An alternative is to solve for
each strike the volatility that would have zeroed the average of the
P&Ls over the different time windows. In other words, in the first
approach, we average the volatilities that cancel each P&L whilst in
the second approach, we seek the volatility that cancel the average
P&L. The second approach seems to yield smoother results.
Break-Even Volatility Computation
The natural way to compute Break-Even volatilities is to seek the
root of the P&L as a function of . This is an iterative process that
involves for each value of the unfolding of the delta-hedging
algorithm for each timestep of each window.
There are alternative routes to compute the Break-Even volatilities.
To get a feel for them, let us say that an approximation of the Break-
Even volatility for one strike is linked to the quadratic average of the
returns (vertical peaks) weighted by the gamma of the option
(surface with the grid) corresponding to that strike.

13th Nov, 2007 Kings College, London

 Strike dependency for multiple
paths

13th Nov, 2007 Kings College, London

 SPX Index BEVL <GO>

13th Nov, 2007 Kings College, London

 New Approach: Parametric BEVL

2 3
Find break-even vols for the power payoffs S , S
This gives us the different moments of the
distribution instead of strike dependent vol which
can be noisy
Use the moment based distribution to get Break
even implied volatility.

Much smoother!

13th Nov, 2007 Kings College, London

 Discrete Local Volatility
Or
Regional Volatility

13th Nov, 2007 Kings College, London

 Local Volatility Model
GOOD

Given smooth, arbitrage free CK ,T 0 K ,T , there is a unique S, t :

1) dS S , t dW (r=0)

2) E ST K CK ,T 0

Given by C
2 K , T
2 K , T 2 T
C
K , T
K 2

BAD
Requires a continuum of strikes and maturities
Very sensitive to interpolation scheme
May be compute intensive
13th Nov, 2007 Kings College, London
 Market facts

13th Nov, 2007 Kings College, London

 S&P Strikes and Maturities
K
Sept 07
Aug 07

Dec 07
Oct 07

Mar 08

Jun 08

Jun 09
Dec 08

Mar 09
T
13th Nov, 2007 Kings College, London
 Discrete Local Volatilities
C 0
Ki ,T1 i T1 ,T2 CK ,T2 0 Ki

Price at T1 of C K ,T2 :
T ,T
1 2
K

S0 ,T0
ST1 T1 T2
i CKi ,T1of known pricef
K
Can be replicated by a PF of T1 options:

ST1
K
13th Nov, 2007 Kings College, London
 Discrete Local Volatilities
f

C K ,T2 0

D
K ,T

Discrete local vol: KD,T that retrieves market price

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 Taking a position
Local vol = 5%
User thinks it should be 10%

13th Nov, 2007 Kings College, London

 P&L at T1
Buy C K ,T2, Sell 5%C
i Ki ,T1

13th Nov, 2007 Kings College, London

 P&L at T2
Buy C K ,T2, Sell i 10%CKi ,T1

13th Nov, 2007 Kings College, London

 Link Discrete Local Vol / Local
Vol
dS S , t dW
Assume real model is:

K
KD,T is a weighted average of
with the restriction of the Brownian
Bridge density between T1 and T2
S0 ,T0
T1 T2

Market prices tell us about some averages of local volatilities -

Regional Vols
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 Numerical example

13th Nov, 2007 Kings College, London

 Price stripping
Finite difference approximation:
C CK ,T T CK ,T
2 K , T 2 C 2
2 K , T 2 T T T
C KK C CK K ,T CK K ,T 2CK ,T
K , T
K 2
K 2
Crude approximation:
for instance constant volatility
(Bachelier model)
dS dW
K
does not give constant discrete local T
volatilities:

13th Nov, 2007 Kings College, London

 Cumulative Variance
2
VK ,T K ,T T
Nave idea: K K
T2

VK ,T2 VK ,T1 2 K , t dt
T1 S0 ,T0
T1 T2
Better approximation:

T
K
S 0 K S 0 , t dt
2 t
VK ,T K'
0 T
t T1
T2

VK ,T2 VK ',T1 K '

2
K K ', t dt S0 ,T0
T1 T2 T1 T1 T2
13th Nov, 2007 Kings College, London
 Vol stripping

T
The approximation
VK ,T 2 S0 K S0 , t dt
t leads to
0 T

V V K S 0 V 1
K , T
2
where u K S0
u T T K
T
T
Better: following geodesics: VK ,T 2 f K ,T t , t dt
0

V V V 1
K , T
2
f K ,T T
'
u '

where
u T K f T
K ,T
Anyway, still first order equation
13th Nov, 2007 Kings College, London
 Vol stripping
The exact relation is a non linear PDE :

V
S K V S0 K
2
V 2 1 2V
2 K , T 1 0
1

T V K 2V 4V K 2 K 2


Finite difference approximation:
TV
K , T
2

S K 0
2

1 0
KV
S K

1 KV KK V
2 1

V 2V 4V 2
Perfect if dS dW : KFD,T

K
T
13th Nov, 2007 Kings College, London
 Numerical examples
BS prices (S0=100; =20%, T=1Y) stripped with Bachelier formula
th=.K

estimated th

Price Stripping
Vol Stripping

K
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 Accuracy comparison
th estimated
1

2
T K
K S0
1 K , T T V KV
2

T
TV
2 K , T
2
(linearization of 3 )
S K
1 0 KV
V
TV
3 K , T
2

S0 K S0 K 2 1
KV KK V
1
1 KV
2

V 2V 4V 2
13th Nov, 2007 Kings College, London
 Local Vol Surface construction
Finite difference of Vol PDE gives averages of 2, which we use to build
a full surface by interpolation.
Interpolate 2 K, T from
Ki2
T j T j 1
2 K i , Ki 1
2
TV Ki
S0 K S K 1
2

KV KK V
1
1 KV 0
2
Ki 1
V 2V 4V 2

with Vi , j 1 Vi , j
K i2
TV
T T j 1 Tj T j 1
1 Vi 1, j Vi 1, j Vi 1, j 1 Vi 1, j 1
KV
2 2K 2K

KK V
1 Vi 1, j Vi 1, j 2Vi , j Vi 1, j 1 Vi 1, j 1 2Vi , j 1

(where Vi , j V K i , T j )
2 K 2 K 2
13th Nov, 2007 Kings College, London
 Reconstruction accuracy

Use FWD PDE C 2

2
C to recompute

T 2 K 2
option prices

Compare with initial market price

Use a fixed point algorithm to correct for convexity bias

13th Nov, 2007 Kings College, London

 Conclusion

Local volatilities describe the vol information and

correspond to forward values that can be enforced.

Direct approaches lead to unstable values.

We present a scheme based on arbitrage principle to

obtain a robust surface.

13th Nov, 2007 Kings College, London