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Some Practical Issues in FX and Equity

Derivatives

Phenomenology of the Volatility Surface


The volatility matrix is the map of the implied volatilities quoted by the
market for options of different strikes and different maturities. Implied
volatility is the parameter needed to calculate the B&S formula. In
practice the matrix can be built according to two main rules:
Sticky Delta: the matrix of implied volatilities is mapped, for each
expiry, with respect to the of the option; this rule is usually adopted
in the over the counter markets (e.g.: fx options). Options are priced
depending on their . That has subtle implications for the running of a
book of options.
Sticky Strike: the matrix of implied volatilities is mapped, for each
expiry, with respect to the strike prices; this the rule is usually adopted
in official markets (e.g.: equity options and futures options). Implied
volatilities remain constant for each strike, even if the underlying asset
price changes.

Phenomenology of the Volatility Surface


Sticky Delta Rule: For each strike K and expiry T the implied volatility
of any option is dependent on the level of its and consequently on the
movements of the underlying asset (and on the elapsing of time).

Phenomenology of the Volatility Surface


Sticky Strike Rule:For each strike K and expiry T the implied volatility of
any option is independent of the movements of the underlying asset.

Sticky Strike Arbitrage


Consider the P&L of a perfectly hedged portfolio in a short period dt:
P &L = d + f = dC dS + f
where f is the financing cost of the position.
Lets assume the underlying assets evolution is commanded by a
Brownian motion:
dS = Sdt + tSdZ
and apply Itos lemma (note that t is the actual and not the implied
volatility)
1 2 2
dC = ( + t S + )dt + tSdZ
2

Sticky Strike Arbitrage


Since f is:

f = (rd(t)C + rd(t)S rf (t)S)dt


= (rd(t)S + Df drd(t)K(d2) + rd(t)S rf (t)S)dt
we get

1 2 2
S dt
dt + f = K
2
and hence (recalling definition):
1
2
]dt
P &L = S 2[t2 K
2

Sticky Strike Arbitrage


Now, lets assume we have two call option C1(K1, 1) and C2(K2, 2)
with 1 > 2. We build a portfolio such as: long 1 options C2 and
short 2 options C1
The P&L in the interval dt is.
1 2 2
S [1 2]dt
P &L =
2
which is a positive amount.
Thus Sticky Strike rule imply an arbitrage if it is realized in the market

Sticky Delta Arbitrage


The Sticky Delta rule imply arbitrage as well, if it is realized in the
market, though in less evident way.
One should consider the shape of the surface in terms of slope and
convexity and then build complex portfolios
Generally speaking, with relatively symmetric matrices (such as in the
Eur/Usd FX market), a position short butterfly grants a positive and
positive portfolio.
A short butterfly = long an ATM straddle and short a symmetric
strangle (e.g.: short a 25 Call and a 25 Put), in an amount such that
the total Vega of the portfolio is nil

Conclusions on the Sticky Strike and Sticky Delta Rules


Matrices with different implied volatility for different levels of strike show
that the constant volatility assumption of the B&S model is not realistic.
The two Sticky Strike and Sticky Delta rules imply arbitrage should they
actually be realized: so they both cannot be considered as a feasible
model of the evolution of the volatility surface.
They can be considered just as two convention for quoting volatility
surfaces and they are respectively chosen according to their suitability to
different markets.

Phenomenology of the Volatility Surface


The evolution of the volatility surface can be decomposed in three main
movements, for each expiry:
Parallel Shift
Convexity Increase/Decrease
Slope Increase/Decrease.
To represent these movements in terms of market instruments, one can
consider:
The ATM straddle volatility as an indicator of the level
The Vega Weighted Butterfly as an indicator of the convexity
The Risk Reversal as an indicator of the slope.

Phenomenology of the Volatility Surface


Parallel

Phenomenology of the Volatility Surface


Convexity

Phenomenology of the Volatility Surface


Slope

Phenomenology of the Volatility Surface


Composite

Model Risk in Hedging Derivatives Exposures


Every time we choose a model to price and to hedge a derivative, we
make more or less realistic assumptions about the risk factors we want
to take into consideration.
In practice, markets never behave in the way predicted by the model, so
that the risk one incurs in by using a misspecified model is very high.
In order to minimize the model risk, one can analyze which is the hedging
error arising from the non-realistic modeling of the factors included in
the model; subsequently, one tries to minimize this error.
In what follows we will analyze which is the hedging error produced by
the false assumption of a constant volatility (as in the B&S model).
We also analyze which is the error produced by the more realistic
assumption of a changing implied volatility, in case we are not able to
correctly describe its evolution.

Model Risk: Hedging by B&S (constant volatility)


We have shown above that the P&L in short interval dt of a perfectly
hedged (under B&Ss assumptions) portfolio is:
1
2
P &L = S 2[t2 K
]dt
2
We make a profit if the realized volatility t higher than the implied
volatility K , and the magnitude of this profit is directly linked to the
level of the (which is always positive in the case of a plain vanilla call
option).
If we integrate over the entire options life, we obtain the total P&L
resulting from running a -hedged book at constant implied volatility:
Z T
1 2
2
P &L =
St (St, K , t)[t2 K
]dt
2
0

Model Risk: Hedging by B&S (constant volatility)


From the formula above we can infer that:
Continuous -hedging of a single option revalued at a constant volatility
generates a P&L directly proportional to the of the option;
In general the P&L of a long position in the option, continuously rehedged, is positive if the realized volatility is, on average during the
options life, higher than the constant implied volatility; it is negative in
the opposite case;
The previous statement is not always true since the total P&L is
dependent on the path followed by the underlying: if periods of low
realized volatility are experienced when the is high, whereas periods of
high realized volatility are experienced when the is negligible, then the
total P&L is negative, though the realized volatility can be higher than
implied volatility for periods longer then those when it is lower.

Model Risk: Hedging by a Floating Implied Volatility


In practice, every day the traders book is marked to the market, so to
have a revaluation as near as possible to the true current value of the
assets and other derivatives.
That means that the book is revaluated at current market conditions
regarding the price of the underlying asset and the implied volatility (we
drop for the moment the fact that also the interest rates are updated to
the current level).
We would like to explore now the impact on the hedging performance
when the implied volatility is floating and continuously updated to the
market levels.

Model Risk: Hedging by a Floating Implied Volatility


Under the real probability measure P, the underlying assets price evolves
according to the following SDE:
dS = Sdt + tdZ1
The implied volatility K is now considered as a new stochastic factor
and model its evolution, under the real probability measure P, as:
dK = dt + tdZ2
where dZ1 and dZ2 are two correlated Brownian motion.
Under the equivalent martingale measure Q:
dS = (rd rf )Sdt + tdW1
d
K =
dt + tdW2
where dW1 and dW2 are again two correlated Brownian motion with
correlation parameter .

Model Risk: Hedging by a Floating Implied Volatility


Under the real probability measure P, the options price evolves as:

C 1 2C 2 2 C
C
dC =

+
S +
S +
t
2 S 2 t
S
K

C
C
2C
1 2C 2
+
2 t + S t St dt + S t SdZ1 + t dZ2
2 K
K
K
or, writing the partial derivatives as Greeks:

1
1 2 2
2
dC = + t S + S + V + Wt + X tSt dt + tSdZ1 + VtdZ2
2
2
where V is the Vega, X is the vanna and the W is the volga.

Model Risk: Hedging by a Floating Implied Volatility


Under equivalent martingale measure Q the dynamics of the call option
is:
1
1
dC = + t2S 2 + (rd rf )S + V
+ Wt2 + X tSt = rdC
2
2
Lets build a portfolio of: long one call option and short quantity of
the underlying; its P&L over a small period dt is:
d = dC dS + f
where f is the cost born to finance the position:
f = (rd(t)C + rd(t)S rf (t)S)dt

Model Risk: Hedging by a Floating Implied Volatility


After a few substitutions we get

1 2 2
1
d
f
2
d = + t S +(r r )S+V+ Wt +X tSt dtrdCdt+VtdZ2
2
2

Adding and subtracting V


and by means of previous equations we have
d = VtdZ2 + (V V
)dt = V(dk
dt)
By integrating over the options life:
P &L =

d =

V(dk
dt)

Model Risk: Hedging by a Floating Implied Volatility


From the formula above we can infer that:
Continuous -hedging of a single option revalued at a running implied
volatility generates a P&L proportional to the Vega of the option.
In general the P&L of a long position in the option, continuously rehedged, is positive if the realized variation in implied volatility is, on
average during the options life, higher than its expected (risk-neutral)
variation, it is negative in the opposite case.
The previous statement is not always true since the total P&L is
dependent on the path followed by the underlying: if periods of low
realized variations of the actual implied volatility are experienced when
the Vega is high, whereas periods of high realized variations of the actual
implied volatility are experienced when the Vega is negligible, then the
total P&L is negative, though the realized variations could be on average
grater then expected implied volatilitys variation.

Hedging Volatility Risk in a B&S World


In practice, the a traders book is frequently updated in terms of the
underlying asset price and implied volatility. If the book is re-valued and
hedged as in a B&S world, then we know from the previous analysis that
we have to minimize the model risk by minimizing the Vega exposure.
Then the book will be -hedged against the movements of the underlying
asset; it will be Vega-hedged against the change in the implied volatility.
Vega-hedging must be considered in a very extended meaning: the
portfolio must remain Vega-hedged even after movements in the implied
volatility and/or the underlying asset.

Hedging Volatility Risk in a B&S World


So, hedging a book in a B&S world implies setting to zero the following
Greeks:

V
X (Vanna or DvegaDspot)
W (Volga or DvegaDvol)
The exposure is (usually) easily set to zero by trading in the underlying
assets cash market. The volatility-related Greeks are set to zero by
trading (combinations of) other options.

Hedging Volatility Risk in a B&S World


Tools to cancel Vega exposures are:
ATM straddle: this structure has a strong Vega exposure, low Volga
exposure and nil Vanna.
Risk Reversal 25: no Vega and Volga exposures, strong Vanna exposure.
Vega Weighted Butterfly 25: no Vega and Vanna exposures, strong
Volga exposures.
By combining the three structures above, traders make their book
Vega-hedged, and the keep this hedging stable to implied volatility ad
underlying asset movements.

Hedging Volatility Risk in a B&S World


Exotic option (e.g.: barriers and One Touch) often show more sensitivity
to the Volga and to the Vanna than to the Vega.
As an example we consider an Up&Out Eur Call Usd Put option:
Spot Ref.: 1.2183
Expiry: 6M
Strike: 1.2250
Barrier Up&Out: 1.3100

Hedging Volatility Risk in a B&S World


Value
0.0050

0.0600

0.0045
0.0040

0.0500

0.0035
0.0400

0.0030
0.0025

0.0300
0.0020
0.0015

0.0200

0.0010

52

0.0005

0.0100

96

1.41

1.38

1.35

1.29

1.32

1.23

1.26

1.20

1.13

1.16

1.10

1.04

1.4
1

1.3
9

1.3
7

1.3
5

1.3
2

1.3
0

0.0000
1.07

spot

1.2
8

1.2
6

1.2
3

1.2
1

1.1
9

1.1
6

1.1
4

1.1
2

1.1
0

-0.0005

139
1.0
7

1.0
5

0.0000

183

time to
(

Hedging Volatility Risk in a B&S World


Vega
0.0400

0.1000
0.0500

0.0200

0.0000
0.0000
1.0
5
1.0
7
1.1
0
1.1
2
1.1
4
1.1
6
1.1
9
1.2
1
1.2
3
1.2
6
1.2
8
1.3
0
1.3
2
1.3
5
1.3
7
1.3
9
1.4
1

-0.0500

-0.0200

-0.1000
-0.1500

-0.0400

-0.2000
8

-0.2500

-0.0600

52

-0.3000
96

-0.0800

-0.3500

139
1.41

1.38

1.35

1.29

1.32

1.26

1.20

1.23

1.16

1.10

1.13

spot

1.04

-0.1000

1.07

-0.4000
183

time to

Hedging Volatility Risk in a B&S World


Volga
3.0000

6.0000

2.5000

5.0000

2.0000

4.0000

1.5000

3.0000
2.0000

1.0000

1.0000
0.5000
0.0000

1.4
1

1.3
9

1.3
7

1.3
5

1.3
2

1.3
0

1.2
8

1.2
6

1.2
3

1.2
1

1.1
9

1.1
6

1.1
4

1.1
2

1.1
0

-0.5000

-1.0000
1.0
7

1.0
5

0.0000

52

-2.0000
96
-3.0000

-1.0000

139
1.41

1.38

1.35

1.29

1.32

1.26

1.20

1.23

1.16

1.10

1.13

spot

1.04

-1.5000

1.07

-4.0000
183

time to

Hedging Volatility Risk in a B&S World


Vanna
2.5000

40.0000

2.0000
30.0000
1.5000
20.0000

1.0000
0.5000

10.0000

0.0000
8

1.4
1

1.3
9

1.3
7

1.3
5

1.3
2

1.3
0

1.2
8

1.2
6

1.2
3

1.2
1

1.1
9

1.1
6

1.1
4

1.1
2

1.1
0

-0.5000

1.0
7

1.0
5

0.0000

52
-10.0000

96

-1.0000
139
1.38

1.41

1.32

1.35

1.26

1.29

1.23

1.16

1.20

1.10

1.13

spot

1.04

-1.5000

1.07

-20.0000
183

time t

Hedging Volatility Risk in a B&S World


Another example
We consider a Down&Out Eur Put Usd Call option:
Spot Ref.: 1.2183
Expiry: 3M
Strike: 1.2000
Barrier Down&Out: 1.0700

Hedging Volatility Risk in a B&S World


Value
0.0400

0.1200

0.0350
0.1000

0.0300
0.0250

0.0800

0.0200
0.0600
0.0150
0.0400

0.0100

5
26

0.0050

0.0200

48

0.0000

1.33

1.35

1.28

1.30

1.24

1.26

1.20

1.22

1.18

1.14

1.16

1.09

spot

1.11

1.1
0
1.1
1
1.1
3
1.1
5
1.1
6
1.1
8
1.1
9
1.2
1
1.2
3
1.2
4
1.2
6
1.2
7
1.2
9
1.3
0
1.3
2
1.3
4
1.3
5

69
0.0000
91

time to
(d

Hedging Volatility Risk in a B&S World


Vega
0.2000

0.2000

0.1000

0.1000

0.0000
1.1
0
1.1
1
1.1
3
1.1
5
1.1
6
1.1
8
1.1
9
1.2
1
1.2
3
1.2
4
1.2
6
1.2
7
1.2
9
1.3
0
1.3
2
1.3
4
1.3
5

0.0000

-0.1000

-0.1000

-0.2000

-0.2000

-0.3000

-0.3000

-0.4000

-0.4000

5
26
48

-0.5000

-0.5000

69
1.33

1.35

1.28

1.30

1.26

1.22

1.24

1.18

1.20

1.16

1.11

spot

1.14

-0.6000

1.09

-0.6000
91

time to
(

Hedging Volatility Risk in a B&S World


Volga
10.0000

10.0000

8.0000

8.0000

6.0000

6.0000

1.3
5

1.3
4

1.3
2

1.3
0

1.2
9

1.2
7

1.2
6

1.2
4

1.2
3

1.2
1

1.1
9

-2.0000

1.1
8

0.0000
1.1
6

0.0000
1.1
5

2.0000

1.1
3

2.0000

1.1
1

4.0000

1.1
0

4.0000

5
-2.0000

26
48

-4.0000

-4.0000

69
1.35

1.33

1.30

1.26

1.28

1.22

1.24

1.20

1.16

1.18

1.14

spot

1.09

-6.0000

1.11

-6.0000
91

time to
(

Hedging Volatility Risk in a B&S World


Vanna
10.0000

35.0000

8.0000
30.0000
6.0000
25.0000
4.0000
20.0000
2.0000
15.0000
1.3
5

1.3
4

1.3
2

1.3
0

1.2
9

1.2
7

1.2
6

1.2
4

1.2
3

1.2
1

1.1
9

1.1
8

1.1
6

1.1
5

1.1
3

-2.0000

1.1
1

1.1
0

0.0000
10.0000
5.0000
-4.0000
5

0.0000

-6.0000

26

-5.0000

-8.0000

48
-10.0000

-10.0000

69
1.35

1.33

1.30

1.26

1.28

1.24

1.20

1.22

1.18

1.14

1.16

spot

1.09

-12.0000

1.11

-15.0000
91

time to

Hedging Volatility Risk in a B&S World


Given the Vega, Vanna and Volga of an option, we calculate the
equivalent position in terms of three basic options (ATM, 25 Call and
25 Put): these quantities can be easily converted in amounts of the
hedging instruments we have shown above.
The U&O Eur Call Usd Put and the D&O Eur Put Usd Call have a
volatility exposure as presented in the following table:

Up&Out call
Down&Out put

25 put
79,008,643
-400,852,806

25 call
54,195,790
-197,348,566

ATM put
-127,556,533
496,163,095

Table 1: Quantities of plain vanilla options to hedge the barrier options


according to B&S model.

Hedging Volatility Risk in a Stoch Vol World


Managing the volatility risk on the B&Ss assumption is inconsistent and
incomplete.
All the volatility related Greeks are zeroed, but the model assumes that
the impled volatility is constant, so they should not be hedged.
The book is revalued with one implied volatility (typically the ATM),
whereas on the market a whole volatility surface is quoted and it changes
over time (the three movements for any expiry have been analyzed
before).
The pricing of exotic options is not consistent with a volatility surface.

Hedging Volatility Risk in a Stoch Vol World


Need for a model to capture smile effects
Non-lognormal models (e.g.: CEV)
Local-volatility models (e.g.: Dupire)
Stochastc Volatility models (e.g.: Heston, SABR)
Lognormal Mixture models (e.g.: Brigo & Mercurio; Brigo Mercurio &
Rapisarda)

Hedging Volatility Risk in a Stoch Vol World


Example: we try to hedge the volatility risk by the Brigo, Mercurio &
Rapisarda (2004) model.
The hedging procedure is based on the concept of sensitivity bucketing
and reflects what a trader is willing to do in practice. This is possible
thanks to the model capability of exactly reproducing the fundamental
volatility quotes (at least for the three basic instruments).
One shifts such a volatility by a fixed amount , say ten basis points.
One then fit the model to the tilted surface and calculate the price of
the exotic, N EW , corresponding to the newly calibrated parameters.
Denoting by IN I the initial price of the exotic, its sensitivity to the
given implied volatility is thus calculated as:
N EW IN I

Hedging Volatility Risk in a Stoch Vol World


In practice, it can be more meaningful to hedge the typical movements
of the market implied volatility curves. To this end, we start from the
three basic data for each maturity (the ATM and the two 25 call and
put volatilities), and calculate the exotics sensitivities to:
i) a parallel shift of the three volatilities;
ii) a change in the difference between the two 25 wings;
iii) an increase of the two wings with fixed ATM volatility.
This is actually equivalent to calculating the sensitivities with respect to
the basic market quotes. In this way we capture the effect of a parallel,
a twist and a convexity movement of the volatility surface.
Once these sensitivities are calculated, it is straightforward to hedge the
related exposure via plain vanilla options, namely the ATM calls, 25
calls and 25 puts for each expiry.

Hedging Volatility Risk in a Stoch Vol World


We use the following volatility surface and interest rate data

1W
2W
1M
2M
3M
6M
9M
1Y
2Y

AT M
13.50%
11.80%
11.95%
11.55%
11.50%
11.30%
11.23%
11.20%
11.10%

RR
0.00%
0.00%
0.05%
0.15%
0.15%
0.20%
0.23%
0.25%
0.20%

V W B
0.19%
0.19%
0.19%
0.21%
0.21%
0.23%
0.23%
0.24%
0.25%

P d(0, T )
0.9997974
0.9995851
0.9991322
0.9981532
0.9972208
0.9941807
0.9906808
0.9866905
0.9626877

P f (0, T )
0.9996036
0.9992202
0.9983883
0.9966665
0.9951018
0.9902598
0.9855211
0.9807808
0.9550092

Table 2: Market data for EUR/USD as of 31st March 2004.

Hedging Volatility Risk in a Stoch Vol World


The hedging quantities calculated according to UVUR model with the
scenario approach are shown below.
The expiry of the hedging plain vanilla options is once again the same as
the corresponding barrier options.
It is noteworthy that both the sign and order of magnitude of the hedging
options is the similar to those of the BS model we calculated before.

Up&Out call
Down&Out put

25 put
76,409,972
-338,476,135

25 call
42,089,000
-137,078,427

ATM put
-117,796,515
413,195,436

Table 3: Quantities of plain vanilla options to hedge the barrier options


according to UVUR model with the scenario approach.

Analogies between B&S and Stoch Vol Hedging


The sign and magnitude of the hedging quantities show that some analogies
exist between the exposures of an option priced by a B&S model and a
model which consider the smile effects.
The B&S Vega can be though of as the equivalent of the sensitivity of
the option price to a parallel shift of the volatility surface.
The B&S Volga is the equivalent of the sensitivity to a change in the
convexity of the volatility surface, i.e.: an upward or downward movement
of the wings with respect to the ATM level.
The B&S Vanna is the equivalent of the sensitivity to a change in the
slope of the volatility surface, i.e.: a twist of the wings with respect to
the ATM level, considered as a pivot point.

More Risks
Other risks, related to plain vanilla and exotic options, have to be managed
P (Rho) and exposure, i.e.: the sensitivity of the option price to the
domestic interest rate and the foreign interest rate, or dividend yield in
case of equity option.
Risks related to some exotics, e.g.: gap at the breach of the barrier.
Correlation risk: many exotic options (especially in the equity market)
have as underlying basket of stocks, or the pay-off is contingent on the
future evolution of a given number of stocks. In these cases, correlation
between the single assets become a main risk.

Correlation Risk
As an example of correlation risk, we discuss three different option types
with the following payout structures
An at-the-money (ATM) call option on an equally weighted basket of n
stocks.
An option on the maximum performance of n assets
An option on the minimum performance of n assets.
Payouts are defined relative to Si, i = 1, .., n i.e.: the asset price at the
expiry T = 0.

Correlation Risk
The risk management of multi-asset options implies the canceling of the
first and second order spot and volatility sensitivities, though in this case
we have to deal with matrices of sensitivities :
The vector

C
Si

The matrix

C
Si Sj

The Vega vector

C
i

The Volga matrix


The Vanna matrix

C
i j
C
i Sj

First-order correlation risk (correlation Vega) can be calculated as a


C
with i < j.
triangular matrix
ij

Correlation Risk
Single stocks and plain vanilla options on single stocks hedge only the
the Vega and the diagonal elements of the , Volga and Vanna matrix.
The remaining risks, i.e. the nondiagonal elements (cross , cross Volga
and cross Vanna) and the correlation Vega, can be hedged only by other
multi-asset options.
It can be shown that in a B&S world the following relationship holds:
C
C
= Si Sj i j T
ij
SiSj
So that by hedging all the cross exposure one hedges also the correlation
Vega exposures.

Correlation Risk
The correlation risk affects the price of an options in two ways, depending
also on the kind of pay-off of the structure:
It impacts on the volatility of the entire basket of underlying stocks.
It impacts on the dispersion of the single stocks within the basket.
We make some intuitive considerations on these two effects with respect to
the three kind of exotic options we listed above.

Correlation Risk
Basket options:
The value of the option is affected only by the basket volatility.
The dispersion of individual assets does not influence the option price,
because the payout only depends on the sum of the asset prices at
maturity.
Higher correlations increase basket volatility and thus the option price.
Hence basket options are long in correlation.

Correlation Risk
Options on the Maximum:
Increasing correlations imply higher volatility of the basket
Increasing dispersion of the single stocks increases the probability of any
stock to reach a very high value at maturity. This effect grows with
declining correlations.
So for max options, the two effects operate in opposite directions.
From moderate to high correlation, option prices decrease with increasing
correlation: hence, the dispersion effect is stronger than the basket
volatility effect and the max option is short in correlation.
It should be stressed that this is the initial exposure when the Si(0) are
fixed. Situations can occur where the max option is both short and long
in correlation depending on the specific levels of correlation and spot
prices.

Correlation Risk
Options on the Minimum:
The min option is affected by both effects, but both take the same
direction in this case.
The dispersion effect increases option prices as correlations become
higher, since this minimizes the probability that any asset reaches a very
low level at maturity and maximizes the value of the min option
Higher correlation implies also a higher volatility of the basket and this
increase the option value.
Since both effects operate in the same direction, the correlation sensitivity
is positive and especially high for this option type.

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