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# Applied Mathematical Finance 2, 117-133 (1995

)

Uncertain volatility and the risk-free synthesis of derivatives

T.J. LYONS

4 Mark Terrace, The Drive, Wimbledon, London SW20 8TF, UK

To price contingent claims in a multidimensional frictionless security market it is sufficient that the volatility of the security process is a known function of price and time. In this note we introduce optimal and risk-free strategies for intermediaries in such markets to meet their obligations when the volatility is unknown, and is only assumed to lie in some convex region depending on the prices of the underlying securities and time. Our approach is underpinned by the theory of totally non-linear parabolic partial differential equations (Krylov and Safanov, 1979; Wang, 1992) and the non-stochastic approach to Ito's formation first introduced by Follmer (l981a,b).

In these more general conditions of unknown volatility, the optimal risk-free trading strategy will, necessarily, produce an unpredictable surplus over the minimum assets required at any time to meet the liabilities. This surplus, which could be released to the intermediary or to the client, is not required to meet the contingent claim. One sees that the effect of unknown volatility is the creation of a 'with profits' policy, where a premium is paid at the beginning, the contingent claim is collected at the terminal time, but that in addition an unpredictable surplus available as well.

The risk-free initial premium required to meet the contingent claim is given by the solution to the Dirichlet problem for a totally non-linear parabolic equation of the Pucci-Bellman type. The existence of a risk-free strategy starting with this minimum sum is dependent upon theorems ensuring the regularity of the solution and upon a non-probabilistic understanding of Ito's change of variable formulae.

To illustrate the ideas we give a very simple example of a one-dimensional barrier option where the maximum Black -Scholes price of the option over different fixed values for the volatility lying in an interval always underestimates the risk-free 'price' under the assumption that the volatility can vary within the same interval.

This paper puts together rather standard mathematical ideas. However, the author hopes that the overall result is more than the sum of its parts. The ability to hedge under conditions of uncertain volatility seems to be of considerable practical importance.

In addition it would be interesting if these ideas explained some features in the design of existing contracts.

Keywords: volatility, derivative contract, random volatility, Pucci Bellman equation, Black-Scholes Formula

1. Outline

This article is organized as follows.

In Section 2, we develop the modern theory of derivative pr:icing. The material is quite standard; our intention in repeating it is to introduce notation and to develop the theory in a way that allows us to point out the essential perspectives we will retain when we move to unknown volatility.

In Section 3 we develop our main observations. We point out that optimal risk-free hedging strategies exist under our assumptions of unknown volatility. We discuss the relationship between

1350-486X © 1995 Chapman & Hall

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Lyons

the existence of risk-free hedging strategies and of price (this is more complicated than in the complete market situation because of the surplus produced).

In Section 4 we give a slightly artificial example to illustrate that even for a single stock and a volatility trapped between two levels a and b, the maximal Black=Scholes price for a derivative underestimates the funds required by the hedger to meet the contingent claim.

In Section 5 we discuss the implementation of the ideas introduced in Section 3. We also look at the sensitivity of the Black Scholes price to small errors in the volatility; one approach to understanding this is to look at the linearization of the non-linear equation about the Black-Scholes solution.

finally we thank those who have given the author helpful advice and whose contributions were essential for the development of these ideas.

2. Introduction

Later in our discussions we will allow volatility to vary unpredictably and remove all dependence upon probability. But first, it will facilitate discussion and introduce the notation if we briefly describe the standard results on option pricing in continuous time markets. Our approach has more in common with the original papers by Black and Scholes (l973) than with papers emphasizing the martingale representation theorems (see, for example. Harrison and Pliska. 1981). We do not attempt to justify the assumptions made. as the intention of the paper is relax them.

2.1. Definitions and a simple model

Let SI = (Si( L) ),,=1, s, (t) ~ 0 represent the prices of one share in each of a basket! of tradable assets, and suppose the evolution of Sf can be modelled by an Ito stochastic differential equation (SDE):

(1)

where the WI are independent Wiener processes. If the coefficients are assumed to be smooth, then a solution exists for some small time. Provided the rate of return

(2)

is log Lipschit.z (i.e. Lipschi tz in cl-,(!J) and the volatility!

(TU(S,.f) = I:>ik(SI, t)ajIcCSI' t)/(Si(t)Sj(t)) k

(3)

is bounded, then strictly positive solutions will exist for all time.

I We usc the square {Til (S,.I) of the conventional volatility "ii, (SI' 1)/8,(1) as our measure of volatility because it has a dear meaning in multidimensional situations and is uniquely determined by the price process

Uncertain volatility and the risk-free synthesis of derivatives

119

2.2. Capital gain as an ft6 integral

Suppose Vo is the initial wealth in a trust, that its manager is only allowed to invest in the securities lor in cash, and that cash be deposited or borrowed freely at zero rate of interest.i Suppose further that the manager decides to hold ¢;(u) units of asset i at time u. Then it is intuitive, but dangerously imprecise, to expect the capital value of the trust at time t to be

VI = Vo + L JI ¢;(u)ds;(u).

i 0

(4)

Unless the volatility (J of the security process S is identically zero, some of the stock prices will have non-zero local quadratic variation and integrals on the right need careful interpretation.

Taking a pathwise approach, we define the Ito integral to be

J>(s(u), u) • ds(u) := }~~ k~1 g (s (~),:~) (05 e; 1) - s (~,) ). (5)

provided the limit exists. In other words, we define the Ito integral to be the limit of the dyadic forward Riemann sums.

Taking such a pathwisc approach and requiring that dyadic forward Riemann sums converge before we talk about an lt~ integral is quite restrictive. It excludes many classes of integrands to which the standard L2 Ito theorem applies, and for this reason it is not quite the standard approach. However.' it has the advantage of clear financial interpretation. Fortunatciy, it is well known from Ikeda and Watanabe, or from the convergence of the Euler=Maruyama numerical algorithm for the solution of SDEs, that for continuously differentiable g the limit of the righthand side of (5) exists locally uniformly in t with probability one if s is one of the securities in our basket defined in (1) and that it coincides (with probability 1) with any other definition for the Ito integral.

Ifwe look at (5) from the point of view of finance, we could regard the sum on the right to he the capital gain or loss up to time t of a portfolio where as each time kl2n the holding is adjusted to be g units of a stock and where the price of the stock is s. Therefore the lto integral on the left-hand side represents the value of the portfolio if one could trade in finitesimally. The forward nature of the integral is completely natural here .- one would not expect to make decisions about levels of stock holding over a time interval after the prices movement had occurred.

It follows that to make (4) true, we must interpret the integral in the Ito sense and assume that we can trade over sufficiently short time intervals:

Vt = Vo + L JI ¢;(u)· ds;(u) ; 0

(6)

2 This is a purely technical assumption that can be removed in a routine way, at the price of more complicated formulae and slightly less transparent presentation. For this rca son we make the assumption.

3 Tbe importance of the lt~ integral in finance comes precisely from its relationship with forward Riemann sums. This has been noted by Harrison and others. See, for example, Harrison and Schaeffer, and for a mathematical account emphasizing the avoidance of probability see the work of Bick and Willinger (1994).

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2.3. Hedging - attaining a particular terminal value

The art of hedging a financial derivative is to find an investment strategy that produces a sufficient value in the portfolio that it can meet the contingent claim when it is presented. The value of this claim is usually linked directly to the terminal stock price. In other words, given a contractual commitment to pay F( S) at the terminal time, the intermediary must set an initial premium Va and find a hedging strategy CJ, so that

r

F(S) = Vo + L f (,&j(u)dsi(u). (7)

i .0

At first sight this might seem a ridiculous objective; however, it should not be so surprising. Recall from college calculus 'the fundamental theorem of calculus', which states that for smooth paths S = (Sf) and a smooth function F(S) one has

1

F(Sr) = F(So) + L f ~F ds,(u). (8)

i .0 as;

However, this theorem depends on everything being reasonably srnooth.4 In the more general settings of stochastic integrals this statement only holds true for the Stratonovich integral.

The non-trivial quadratic variation of S, forces the fundamental theorem of calculus expressed in terms of the Ito integral to take the unusual form known as Ito's formulae. Suppose I(S, u) is continuously differentiable twice in S and once in u, then

--" f' af

f(8" t) :-:-: f(S[)l 0) + I... as (u)· d.IAu)

i . a ,

f' ( a2 . af")

+ !LUf('fSiaT.f =t: (S",u)du .

. 0 uc t Sf Si (U

(9)

The appearance of the term in the second line of the formula plays a crucial role in identifying riskfree portfolios. The parabolic differential operator

u, .. " ~ L iIijoS,S; ~~---f + of

.. ! (J.~iasl· au

I,IE

(10)

measures the discrepancy when one tries to hedge so as to maintain a portfolio whose value is always given by ft S, t).

In particular, one sees that, providing Lf c= 0, one can with probability 1, hedge a portfolio so that its value at any time is always given by feSt, t). To do this, one holds af/as;(u) units in the ith stock at time 11; in this case the Ito integral on the second line of (9) represents the net trading profit, while the assumption L/ =' 0 ensures that the term on the second line is zero so that trading profit is in precise correspondence to the desired movement of the portfolio. The observation follows.

~ It follows that if stock prices were differentiable (and this remark explains why they are notl) one could hedge so as 10 create a portfolio whose value was always F(S), for any smooth function of the stock price. Choose the function F(S) to be small in a region about the initial price of the stock and large elsewhere to make a fortune. The work of L.C Young establishes Equation (8) if s has finite variation for p < 2 and is continuous.

Uncertain volatility and the risk-free synthesis of derivatives

121

Parabolic partial differential equations like Lf == 0 with given boundary data have been studied by analysts and probabilists for many decades and under smoothness conditions on (jij(s, u) arc well understood. Under mild regularity conditions solutions to Lf == 0 on a given domain U have certain crucial properties:

(i) any solution is uniquely determined by its values as it approaches the boundary (a maximum principle),

(ii) given a function on the boundary of the domain, it is always possible to construct a solution that agrees with it at all regular boundary points (the ability to solve the Dirichlet problem), (iii) the solutions are reasonably smooth within the region (a regularity or Harnack theorem).

Taken with the remarks about the hedging of portfolios, these are the essential facts that allow one to synthesize and price derivatives.

2.4. Synthesis and price

Fix a regular domain U in lJ<t~. x 1Ft, and suppose a bank or intermediary enters into a contract so that on the first occasion T that the security (Su, u) Ieaves ' the domain U, the bank pays the client F(ST, T) >0. (For the example of a European option with strike price K redeemable at a fixed time T, take U = {(x, t)lx > 0, t < T} and F(x, t) = (x ~ K) t.)

Under the assumptions of the model for Su, the above discussion provides answers to the questions: how does the hank ensure that it can fulfil its commitment? How much should it charge?

The most basic result of contingent claim pricing is that if a is known then both questions can be answered." Moreover, the risk-free price and choice of hedging strategy are both independent of the rate of return r.7

2.4.1. The upper bound

To establish an upper bound on the premium an intermediary must charge if he is to be sure that he can always meet his contractual liabilities; one only needs to show that with this amount of money he can trade so that regardless of the particular evolution of the stock price, his terminal portfolio value is always at least F(ST, T).

Consider a minimal position solution to Lf == 0 with f(s, 1') = F(s, t) on the natural parabolic boundary of U (for all inner regular boundary points). Then it is routine thatf(s, t) exists and is

5 This is a European Option; an American option allows one to leave at any time. For simplicity we do not discuss these extensions here, but the scope of our remarks can easily be extended to the wider setting. The main difference is that one has a function defined more generally on U (or even on path space) and one takes the smallest positive supersolution to the heat equation exceeding it quasi-everywhere (potcntial-theorests call this the reduit). The client should cash his option 011 the first occasion the supersolution and the payoff function coincide. If he always does so, then there is no logical distinction between the American option and a carefully chosen European one.

6 It simplifies the discussion to assume that it is always possible to borrow and deposit money at zero interest. If the instantaneous interest rate is not zero, let D, denote the discounted value at time t of 1 unit of currency deposited/borrowed at time zero and consider the discounted value of the securities and portfolio: S,/ D" V,I D,. It is standard and reasonably obvious that everything said in this paper applies if we replace 05" V, by their discounted values.

7 Remember that we are considering discounted prices and payoffs.

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Lyons

twice continuously differentiable (i.e. in C2(U) and is unique. It follows from Ito's formula (9) that for t < T

J.t of

jis; t) =/(50,0) + L a- (u). ds;(u)

i 0 s,

(11 )

and that if (So) 0) E U then

. . fT Df

F(ST, T) = /(50,0) + L a---:- (u). dsJu)

i .0 s ..

. -, 0/ ( ( k ) k) ( (k + [) ( k ) )

= {(So 0) + ""' lim "c' -- s· - - s· -- ... S, -

. , Z:: . L, a I 2n ' 2n '2n , ~"

i n .oc k/2"<r s, \ L }

(12)

From the first line in (12) we sec that the required final payoff can be realized as the sum of an initial termf(So, 0) (the initial premium) and an Ito integral; and we recall, via the second line, that there exists an explicit and feasible discrete-time portfolio management strategy (hedging strategy) that at time T produces a portfolio with value arbitrarily dose to the required F(ST, T). Since (12) holds for almost every path, we have defined an almost surely risk-free continuous hedging strategy. Wc conclude that f(50'0) is an upper bound for the required premium (and for the price, for otherwise another trader would quickly step in with a lower price and still take a risk-free profit.)

Of course there are real-world constraints that affect this approach. Transaction costs. and the discreteness of the market, as well as the inadequacy of the market model, all limit the value of the above. In addition, credit constraints must also playa role as, depending on F and a, it can happen that the strategy calls for negative holdings of some stocks, or negative cash positions depending on the derivative off.

2.4.2. The lower bound

In the previous section we established fV:;'o, O)as an upper bound which worked for almost every path that could be generated by (1) for any value of the rate of return, provided the volatility was kept fixed.

To establish a lower bound on the premium an intermediary must charge if he is to be sure that he can always meet his contractual liabilities, one must give a somewhat different argument. It is sufficient to identify a subclass of the set of all eventualities for the security process, and show that no feasible" strategy that starts with less than x will ensure a terminal portfolio value of at least F(ST, 1') for all paths in this subclass.

For this part of the argument, probability and martingales arc very useful. Littlewood remarked in his miscellany that if one has two functions g(w), G(w) and one would like to prove the existence of a point Wu at which g(wo) < G(wo) then one very effective, if non-constructive, approach is to find a positive measure ii, so thatJg(w)ft(dLv) < f G(w)J1(dw).

s That is, one that does not cheat and look into the future. In mathematical parlance this is a predictable investment strategy 9 In fact Girsanov's theorem shows that this case is not really special at all, but we want to point alit in our presentation that it is irrelevant whether it is special or not. Later in the paper Girsanov's theorem is definitely not available.

Uncertain volatility and the risk-free synthesis of derivatives

123

Consider a set of solutions to (1) of full measure; our subclass of paths will be this set in the special case" where rj ~ 0, "1/

dsJt) = L aj(St, t)dW{ (13)

j

Now consider any initial premium x and any predictable investment strategy 0j(S., u) defined for times u < T and with the convention that trading must cease: if the portfolio value becomes zero. Then with probability one, the value V( S., u) of the portfolio as it will be given by an Ito integral (in the normal stochastic sense)

V(S., U) = x + L Jt (MS., u)dsi(u) t s; T i 0

(14)

Provided the stock holdings (MS., u) are locally bounded as functions of time for almost every realization of S, the integral make sense as a random variable. Much more significantly, as S is the solution to (13), the processes Sand V(S., t) are both positive local martingales (this uses the convention about no trading without assets) and so are positive supermartingales with limits as t ~ T. We can apply the optional stopping theorem (Doob, 1953) to see that

x = V{So,O)

?:E(V(S., T)) (15)

On the other hand, the standard probabilistic approach to solving elliptic and parabolic Dirichlet problems (Doob, 1954) yields the identity giving the minimum solution as an expectation:

f(SOl uo) = E(F(Sr,T)ISuo = so), V(S01 uo) E U (16)

It follows that if x < f(So, 0) then there must be a set of trajectories having positive probability and for which V(S., T) < F(Sr, T). In other words, the hedging strategy fails for this class of paths. This establishes the lower bound on the initial premium a hedger requires to create a portfolio that meets the terminal contingent claim under all circumstances modelled by (I).

We do not argue that we are establishing a lower bound on the market price with the argument above. To obtain a lower bound on the market price, we see that if our intermediary charged less thanf(So, 0) then a client could buy the instrument and hedge the complimentary instrument based on ~F himself to make a sure profit. It seems likely that prices would rise to prevent this. Close inspection of this apparently simple argument shows that it relies on the linearity of the operator L and it will not apply in the case of unknown volatility.

3. The main observations

OUf introductory discussion repeated some very standard material, our purpose being to identify what the author regards as the crucial features in the standard setup which permit the construction of a minimal risk-free hedging strategy, i.e.

(i) a pre-determined volatility for the price process;

(ii) Ito's formula: this showed that it was possible to create a risk-free infinitesimal investment strategy giving a proscribed portfolio value f, provided the latter was a C2 solution to the parabolic differentiation equation Lf ~ 0 associated with the volatility;

(iii) The ability to solve parabolic partial differential equations with given boundary data and obtain C2 solutions;

(iv) A probabilistic argument to show that our initial capital requirement was indeed minimal.

In this section we take the view that the models defined by equation (1) are too restrictive on the one hand and too ambitious on the other, for the following reasons:

• It is a remarkably strong statement to claim that any finite collection of stock prices constitutes a Markov process and forms a complete market. And even if they did, it would be surprising indeed if one could precisely describe the model by which the prices would evolve .

• On the other hand it is not unreasonable to assume that the prices one observes in a fair but uncertain market behave roughly like a semi-martingale, for otherwise arbitrage would be possible. In particular one expects the observed price process to have a finite dyadic quadratic variation (but nothing significantly better as arbitrage becomes possible as soon as the path has finite p-variation for p < 2).

We will relax. these assumptions. while retaining the essence of the observations established above.

3.1. Volatility

We set out our main assumption.

In the previous section wc defined the volatility of the process S" in terms of the coefficients of the defining Equation (I). We now wish to define it as a pathwise concept. Suppose that S; is any path in the space (Rt)1 of possible price vectors;

Definition. We will say a vector valued path Sri in (JR+)I has volatility TiJ(U)/Si~\'i at time II if S" has a finite quadratic variation in the following weak sense: for any continuous paths!', g in rre, the limit

( 17)

should exist and equal

~.L et(u)T'j(ul/;(u)du.

( 18)

and S" should have zero local p-variation for all p > 2.

It is completely standard that almost all solutions to the SDE (l) have this pathwisc q uadratic variation property and that

Tij(U):= (Jij(Su,U)s;Sj (19)

In this ease the volatility is even a predetermined function of the security price and time.

We are interested in studying the possibilities open to an intermediary attempting to create and hedge financial derivatives so that the contingent claim can always be met under the assumption that the security process S" has a volatility process Tij(U)/I'tS/ and un-norrnalized volatility T which

Uncertain volatility and the risk-free synthesis of derivatives

125

is assumed to lie in a given range, but is otherwise unknown. In particular, we make no stochastic assumptions about the price process.

For an example of the sort of range assumption we have in mind, assume that the volatility is bracketed so that ArJ"i/(Su, u)s;Sj < Tij(U) < ArJ"ij(Su, u)SjSj where the comparison is of the matrices in the sense of quadratic forms and not index by index. (On a first read, you may wish to consider the case of one security for in this case all indices are irrelevant.)

It seems to this author that this assumption is vastly more reasonable than the conventional ones.

3.2. A pathwise approach to Ito's formula

Ito's formula is in essence an application of Taylor's theorem and does not require probability. Follmer (1981a,b) noted that the formulae holds for all c2,t functions (functions twice continuously differentiable in space and once in the time variable) and for all paths of finite volatility in the sense introduced above.

That is to say, iff is C2•t and the process Su has un-normalized volatility T, then

Jlof

f(SI' t) =f(So, 0) + L a (u)· dsj(u)

; 0 SI

(20)

where as before

It Df_ (u) . dsiCu) = L }~~ L _{}f (S; (~) 1 -~) (Si (k ~ 1) - s, (~))

o as, j k/2n<tOS, \. 2 2 2 2

Given our earlier discussion, we should already see how to give financial interpretation to such

(21 )

statements.

Consider the extension of the ideas in the introduction.

Let V(s, u) be a C2,l function, and suppose Su is the price process for a vector of tradable assets within-normalized volatility T. Consider the infinitesimal investment strategy which at time u holds a/asj V(Su, u) units of stock i. And suppose that along the trajectory of Su the function V(s, u) is a super solution to the PDE

( a2 av)

! '" 7-'-------.- V + - (5 u)".::: 0

20 IJ n a a u; '"

ijEJ USj Sj U

(22)

the net value W(u) of the portfolio will always grow faster than V(Su; u). In particular, if W(uo) ~ V (SIlG , uo) then W{u) ~ V(Su, u) for U > Uo-

Similarly, a hedging strategy that holds I/W(u)(DjosjlogV(Su,u)) units of stock i is an infinitesimal investment strategy which ensures that W(u)jV(51l1 u) is always increasing. The idea will be to choose one V so that it is a supersolution along any trajectory in our class for all possible choices of the volatility. There will be a smallest such V and it will provide the minimal investment and hedging strategy required to meet the contingent claims under all circumstances.

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3.3. Uncertain volatility - a non-linear PDE

In this section we will argue that the correct price of an option under unknown volatility has two parts - an initial premium reflecting the worst case amount required by the intermediary to meet his commitments, and a well-defined 'cash back' or 'with profits' income stream, which as time evolves is returned by the intermediary to the client. The latter reflects the fact that the risk-free hedging strategy will in general over-reproduce, and we presume that competition would force the intermediary to return funds in excess of the minimum required to meet the contingent claim.l''

Knowledge of the way the volatility moves within its permitted zone might allow one to price the income stream, and so roll it up ill to the price of the option, but this would miss the point. The valuation of this stream is logically distinct from the determination of the minimum risk-free premium required to meet the contingent claim.

The main question we aim to answer in this section is the following: suppose the volatility of the security process is not fully known, is there still an investment strategy which will guarantee that the bank will meet its commitment F(ST, T)?

We will sec, using compactness results from modern POE theory, that the answer is frequently yes. Consider the situation where there exists a basic model Kij(S, u) = u;Js, u)Sjs} for the volatility of securities, but where this model can only be taken as approximate. For example, let Ii! be any positive symmetric matrix and). ,,:; I, A :;>- I, and let

O(A, A, I) = {TijIA LlijVjVj < L: T;}VjVj < A L li/viV;, VIIi}

IJ IJ '.I

(23)

be the neighbourhood of quadratic forms with comparable ellipticity to Ii}' Now make the following assumption.

Assumption. The security process Su admits a volatility Ti;(U) with the property that

(24)

Remarks

(i) The precise choice of definition for region O(s, u) is unimportant, and can be chosen to be any convex family of positive definite symmetric matrices varying smoothly in the (s, u) coordinates.

(ii) We make no probabilistic assumptions about the behaviour of Su'

We now consider the pricing of some derivative instrument. Proceeding broadly as before, fix a smooth domain U in iR~ x 1Ft, and a positive smooth function F(s, u), and suppose that on the first occasion T that the security (.s'u, u) leaves the domain U, the intermediary or bank is contracted to pay the cIientF(ST, T). Assume that the assumptions of the model for S; hold.

!O This is similar to the situation with an American option where at certain times the cost of negotiating a new option giving all the remaining covel' in the existing contract may be less than the yield from terminating the existing contract. Clearly a client who wished to retain the remaining cover could cash the option and take out a new one. If one rolled this into a single instrument it would be an option with a cash back.

Uncertain volatility and the risk-free synthesis of derivatives

127

Consider the Pucci-maximal type equation

(25)

f(s, u) = F(s, u), (s, u) in the parabolic boundary 8p UgU.

Such fully non-linear equations have been extensively studied and are a topic of current mathematical research. For reasonable domains and boundary functions it is a consequence of the parabolic Harnack inequality of Krylov and Safanov (1979) that minimal positive viscosity solutions exist to the above equation. It was showu by Wang (1992) that provided the function I),ij(s, u) is smooth enough and uniformly elliptic, the solutionf to Equation (25) has interior regularity and is at least C2,0!.

It is also shown that the solution f to Equation (25) is also the solution to a linear equation:

(! L iij 8 ~ f) (s, u) + : f(s, u) = 0

i,jEI S, SJ U

(26)

i., E O(A, A, I),ij(s, u)) for a suitable choice of i.

As in the classical situation above, the functionf will again give the correct hedging strategy and the minimal amount the intermediary must hold if he is to pay the contingent claim under all circumstances.

Theorem. There is a hedging strategy that enables an intermediary to start at time zero with f(So,O) units of money, and returns to the client a stream of money amounting to

(27)

at time t, and at time T has exactly F(ST, T) remaining in the portfolio. Provided the volatility assumption (24) is valid, the cash-back stream will always increase with time and no cash call will ever be made on the client.

There is no smaller initial premium and self-sustaining hedging strategy producing at least F(ST, T) for all evolutions of the security process satisfying the assumptions (24) even if no cash is returned to the client.

Proof The argument is virtually identical to that given in Section 2.4.

The lower bound: Consider solutions to the SDE (I) where the coefficients ajk are chosen so that iij(s, t) = Lir ailr(s, t)ajk(s, t) and rj are zero. With probability I they will have volatility iuj and so satisfy the assumption (24). On the other hand, the martingale argument we gave above shows that any risk-free strategy for these paths alone requires an initial premium of at leastf(Sol 0) weref is the solution to linear equation (26). However, our choice of tij ensures that the solutions to (26) and (25) coincide.

The upper bound: We must demonstrate a hedging strategy that, for all paths satisfying the volatility assumption, maintains a value for the portfolio that equals or exceeds

12R

Lyons

(2R)

But we have already explained this point, by the regularity results for solutions the function j" is at least C2". and so we may apply Ito's formulae. If Su is a path with finite volatility Ti/(U), then applying Ito's formulae (9) one has

f(SI,1) =f(50,0) + L f' : feu) .d~;(u) i Jo CSj

+ r (1 L Tjj(U) a a; f +: f) (5", u)du

. 0 jJE! S, S, ( II

(29)

and using the identity (26) one can rewrite this as f(5'" I) =f(So, 0) + ~.L z: (u). dst(u)

+ JI (! 'L,CTiJU) - TO(S,,,u») {) a~ f) (5", u)du

o ijC1 S,C sJ

(30)

Recalling the interpretation of the Ito integral as a hedging strategy, we see that we can reproduce a portfolio with value f and an income stream of cumulative value given by (27). Because

( (2) ( rp)

sup ! L:= TO a . ') .. f (s, u) -= 1 L. rjj [) .[J.f (s, u)

Ti)(O(.\,A."u(s,u)) t,jO s,r ,I, i.j«! s, J.l

(31 )

the income stream will always be positive provided the security process satisfies the volatility assumption (24). This completes the proof.

Remarks

1. The standard Black---Scholes situation corresponds precisely to the case where volatility is known and 0 = {KiJ just a single point,

2. The cash surplus (27) is, under our assumptions, unpredictable and without further information impossible to price. If the market had some knowledge of the likely behaviour of the volatility within the specified band 0, then it would no doubt manage to price the flow. However, such the flow will, by our assumptions, not be hedgeablc, and so the price will carry risk.

3. What should happen to the surplus? It seems clear that the market will force it back to the client. However, this can arise in a number of different ways. The simplest is to allocate the income stream to the client. This is risk-free and simple for the intermediary. An alternative could he to value the income stream and use it to discount the original price of the derivative; however, the intermediary would need to be clear that in doing this it was combining two separate activities with fundamentally different risk profiles. As derivatives are frequently intended to be secure and risk-free insurance policies, one would expect the intermediary

Uncertain volatility and the risk-free synthesis of derivatives

129

to be highly credit-sensitive, in which case it should sell the income stream to a risk-taker, restoring the capital in the trust to the required minimum.

4. At the time of writing, it is normal for the intermediary to assume that the volatility was known, and to take onto himself the risks that come from the volatility changing. Our approach shows how he can insulate himself with an optimal risk-free strategy which works providing the volatility stays in the region 0 and which identifies the shortfall if the volatility moves outside the region.

5. In certain sorts of contract it would seem quite reasonable for the intermediary to refuse to take on the risk that the volatility moves outside the region O.

Consider an intermediary setting up a derivative product to underwrite the performance of a pension fund with defined benefits. The intermediary and the fund could agree a region 0, and price for the derivative, so that, provided the volatility of the securities lay within the stated region, the contingent claims would be met and the surplus defined in (27) would be returned to the contributors to the pension fund; on the other hand, if the volatility went outside the specified zone, additional contributions (as defined by (27») would be required from the contributors to the fund before it could guarantee to meet the liabilities.

In this case the intermediary is purely acting as hedger or trader and is taking no riskY

6. To balance the advantages of stability, there may be considerable disadvantages for the community if intermediaries could distance themselves from the risk of volatility moving outside the region 0 in the way outlined in the previous paragraph. At the moment, considerable effort is expended by intermediaries in trying to identify the likely volatility, and such knowledge leads to more efficient contracts with smaller and carefully selected regions O. It seems unlikely that individual purchasers of derivatives would have the expertise to decide whether the estimates for the volatility used by the intermediary were reasonable. A good compromise could be a situation where the intermediary offers options with cashback for his chosen model of volatility 0, subcontracts the role set out in paragraph 5, and, for part of the initial premium, assumes the risk of the volatility moving out of the target region himself. By ringfencing the subcontractor, one could ensure that even if the risk-taking intermediary went bankrupt, the client could still have the basic underwriting provided by the subcontractor - although he might have to input new cash into the portfolio according to Equation (27) if the assumptions about volatility proved false.

7. One could ask about the behaviour of the initial premium and cash stream when one varies the region O. Clearly, as 0 increases, an application of the maximum principle for linear parabolic equations shows that the solution to the Pucci Equation (25) increases and so the initial premium increases; however, the relationship of the increase in 0 to the income stream is not quite as transparent. It would be interesting to prove whether in all cases where a path was feasible, the price plus cashback was monotone. We have not thought about this, but think it rather unlikely to be true.

11 We are always assuming friction-free trading. Of course the introduction of trading costs changes the picture to a significant extent.

130

Lyons

We conclude that even under uncertain volatility there is always a correct minimum portfolio value and investment strategy that will ensure that all contingent claims will be met However, for most realization of the path the investment strategy will produce a surplus, We observe that uncertainty in the volatility is countered by the creation of a 'with profits' portfolio and that rolling that profits into the price of the derivative substantially changes the risk profile faced by the intermediary.

4. Examples

4.1. Maximum volatility sometimes predicts the risk-free premium

There is a particular case where the optimal strategy given by the non-linear Pucci minimal equation has a simple solution. Suppose Su is one-dimensional, that the volatility lies in [.\K(S), AK(S)] where /I",(s) is time-independent, that U = lR_,_ x [0, T] for a fixed time T and that K(s)(d2/di)F(s) ~ ° for all s ~ o.

In this case one readily checks that if f: is the solution to

ri D

A4v) DS2f(S, u) + 8/(s, u) = 0

(32)

the f.. is also the solution to the Pucci minimal operator. To prove this, observe first that K(S) (82/8i)f is a solution to Equation (32) iff is, and second we can apply the maximum principle to observe that if I>; (s)& /(8i)f ~ 0 on the boundary lR'.+ x {T} of U, then K(s)((i/Di)f ~ 0 everywhere in U. It follows that

sup yes) cr2f(S, u) = AK(S) 8El2f(S, u)

TEO(A,JI.,,,(s.u)) 8s S

(33)

and consequently [: is the solution to the minimal Pucci operator.

The classic example where K(S) = i and F(s) = (s - K)+ satisfies this last hypothesis as i(d2/di)p = 8K where 8K is a delta function with its mass concentrated at the strike price, K.

So in this important special case, the minimal risk-free premium and hedging strategy coincide with the classical price and hedging strategy under the assumption of maximal volatility, although in general the adopted hedging strategy will yield a profit that needs to be accounted for. In general, and particularly in dimensions greater than one, one should not expect this result to be true or to have many analogies.

4.2. Maximum volatility sometimes underestimates the risk-free premium

Even in the simple situation where S" is one-dimensional and the volatility lies in [..\K(s),A/I",(s)] where K(S) is time-independent, it can happen that by assuming a maximal volatility AK(S) (or any other constant volatility) one can underestimate the risk-free premium the intermediary requires.

Consider a barrier option where U = [0, R] x [0, ToJ, and the payoff function F(R, u) = 0 for u < 1'0 and pes, To) = (x- K) t • Suppose that the volatility lies in the range [.\S2, Ai].

Uncertain volatility and the risk-free synthesis of derivatives

131

In other words, the option pays nothing if the asset value exceeds R at some time before the terminal time but otherwise pays (x - K)+ at the terminal time. The volatility assumption is of the simplest kind.

Then one sees that no solution to an equation of the form

2& D

res 8sf(s, u) +- {J/(s, u) = 0

f(R, u) = 0, u < To, f(s, '1'0) = (s - K) t-

(34)

can possibly be wholly convex or wholly concave in s for all S,I1. Suppose it were possible, we can argue by contradiction. The boundary constraints forcef to be positive and to converge to zero at both edges of the interval [0, R] for each fixed time. Therefore it must be concave in s. However, lim/ .. l0 f is strictly convex at K, producing the contradiction.

It follows that no solution to (34) can possibly be a solution to the Pucci maximal equation and that the solution to the Pucci equation will be strictly greater than any solution to (34).

In these examples, assuming that the volatility is maximal within the given range underestimates the risk-free premium required to tackle all possible eventualities.

The reader interested in these one-dimensional examples should also consult Karoui and Jeanblanc-Picque (1993), who consider the case of an incomplete one-dimensional market modelled by an SDE with a random volatility, and examine the pricing of an option on a security whose volatility was restricted to lay in an interval. In this context, they discuss superstratcgies and observe (Theorem 2), as we have done here, that if the payoff function is convex then hedging using the classical Black-Scholes formula with the highest permitted constant value of the volatility will always produce a super reproducing strategy.

Tn the same paper, the authors give a slightly misstated counterexarnple.i ' due to Marc Yor, where two securities are compared. This example, like our one above, underlines the need for care in the formulation of comparison results and the danger of assuming that a simple Black Scholes model will bound the risk-free premium.

5. Linearization and computation

To give the division of the price of a derivative into its risk-free and cash-back components more than theoretical interest, it is necessary that numerical computations of the solution to the Bellman-Pucci equation are feasible. In practice, this seems the case for low-dimensional systems, the crucial point being that the equation is parabolic and so normal backward methods can be applied with the difference that care is taken to use the locally maximizing difference equation at each step. We have no difficulty'f computing the numerical solution Ito the option introduced above in Equation (34). Figure 1 shows the barrier option with strike price I and zero payout if the price

12 Their paper claims in several places that the counterexample works for all convex functions; however, we take this claim to be a linguistic error as the proof given only shows the existence of one convex function and counter examples show that 'lemma I' is not true as stated.

13 However, W~ were not too naive in our choices of difference operators.

132

portfolio required

OJ

0.4

0.3

0.2

o.t

Fig. 1. Barrier option

Lyons

0.5

1.5

2

25

ever drops lie or exceeds e. The dashed lines give the conventional Black=Schok-s price for differing volatilities (the more black, the higher the volatility). The continuous line. lying above all the others in the solution to the Pucci=Bellman equation where the volatility is assumed to be sandwiched between the lowest and the highest of the fixed volatilities shown. but is otherwise unknown.

Perhaps the most striking feature of the comparison between solutions is the way that the B13ck Scholes prices arc in reasonable agreement for different volatilities ncar the strike price: this would probably give the intermediary confidence that this is indeed the correct and reasonably risk-free price. However, the minimal risk-free premium is considerably higher than these models would suggest. Indeed the discrepancy between the approaches is maximal around the point where the Black -Scholes models agree.

Although it seems relatively easy to numerically compute solutions to the non-linear equation directly, one can imagine situations where one would like a rough and ready estimate for the extent that one can rely on the Black -Scholes price for a risk-free hedging strategy under conditions of volatility uncertainty. In this case one could differentiate the solution to the Pucci Bellman equation around the Black-Scholes solution. This derivative function would highlight the sensitivity of the price to volatility movements far better than maximizing the solution to the Black -Scholes mode over varying volatility. The advantage of doing this is that the resulting equation for the derivative function is a linear parabolic equation of Poisson type and, at least for explicit models such as the classical Black=Scholes equation, is amenable to solution.

To explain a little more precisely, supposef is the solution to the Bellman Pucci equation where the volatility lies in [.\K,(S, t)AK(S, t)] and {.\, A} = {l-- eh, 1 + fh}. Suppose that f. is small and consider Jim,~o(r. -f)/f, wheref is the solution to the related limiting Black -Scholes equation.

Uncertain volatility and the risk-free synthesis of derivatives

133

Then it is a routine exercise (if a slightly non-rigorous one) to determine the limit. This is the solution to the linear PDE:

(! L "'ij 0 ~~ J) (s, u) + : g(s, u) = - . sup (! L(T!j - Kij) {) ~.f) (s, u)

i,jEI S, 5} U T,JEO(>..A,I<.;,( .. ,u)) i,jEJ S, ~)

g(s, u) = 0, (s, u) E op U

One can see from its definition that it is a useful measure of the deviation of the risk-free premium from the Black-Scholes price under small fluctuations in the volatility.

Acknowledgements

The author would particularly like to thank Hans Follmer, Stephen Schaeffer and Paul Wilmott who read versions of the manuscript and made a range of very useful comments. Particular thanks go to Luis Escauriaza, who during a walk in Edinburgh, introduced him to the modern literature on Pucci Maximal operators, and to his wife Barbara, without whose typing and encouragement at a bleak time this manuscript would probably never have been written.

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