Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
Overview
o FX Markets
o Possible Models and Calibration
o Variance Swaps
o Extensions
3
FX Markets
o Market Features
o Liquid Instruments
o Importance of Forward Smile
Spot
Spot
114
117
102
105
108
120
123
126
129
132
135
111
99
28Nov01
28Feb02
31May02
02Sep02
03Dec02
05Mar03
05Jun03
05Sep03
08Dec03
09Mar04
09Jun04
USDJPY Spot
USDJPY Spot
09Sep04
Spot
10Dec04
14Mar05
14Jun05
14Sep05
15Dec05
17Mar06
19Jun06
19Sep06
16Dec06
99
111
114
117
102
105
108
120
123
126
129
132
135
4
Volatility
Volatility
10
12
13
14
15
16
17
4
5
6
7
8
9
11
28Nov01
28Feb02
31May02
02Sep02
03Dec02
05Mar03
05Jun03
05Sep03
08Dec03
09Mar04
09Jun04
09Sep04
14Mar05
14Jun05
14Sep05
15Dec05
17Mar06
19Jun06
19Sep06
14Dec06
4
5
6
7
8
9
11
10
12
13
14
15
16
17
5
6
• Quotes available
– Delta-neutral straddle ⇒ Level
– Risk Reversal = (25-delta call – 25-delta put) ⇒ Skew
– Butterfly = (25-delta call + 25-delta put – 2ATM) ⇒ Kurtosis
Risk-Reversals
11
10.5
10
9.5
Implied Volatility
8.5
7.5
6.5
6
10C 25C ATM 25P 10P
Delta
8
10
10
9.5
9.5
Volatility
1M
ImpliedVolatility
1M
99 1Y
1Y
8.5 2Y
2Y
8.5
Implied
88
7.5
7.5
77
6.5
6.5
66
10C
10C 25C
25C ATM
ATM 25P
25P 10P
10P
delta
delta
9
• Calibrating to the barrier products means we are taking into account the forward
implied volatility surface
10
Double-No-Touches
• Pays one if barriers not breached through lifetime of product
U
FX rate
L
0 T
time
Double-No-Touches
• For constant TV, barrier levels are a function of expiry
140
130
120
B a rrie r L e v e l
110
100
90
80
0 0.5 1 1.5 2
Expiry
12
• Three aspects
– Final payoff (Call or Put)
– Pay if barrier breached or pay if it is not breached (Knock-in or Knock-out)
– Barrier higher or lower than spot (Up or Down)
One-Touches
• Single barrier product which pays one when barrier is breached
• There is some price visibility for one-touches in the leading currency markets
Replicating Portfolio
60
60 70
70 80
80 90
90 100
100 110
110 120
120
B K Spot
15
Replicating Portfolio
u<T
B K Spot
16
Replicating Portfolio
u<T
B K Spot
17
One-Touches
• For Normal dynamics with zero interest rates
One-Touches
• Log-Normal dynamics
One-Touches
• Introduce skew
Model Skew
• Model Skew : (Model Price – TV)
• Can also consider market-implied skew which eliminates effect of particular market
conditions (eg interest rates)
21
o Local Volatility
o Heston
o Piecewise-Constant Heston
o Stochastic Correlation
o Double-Heston
22
Local Volatility
• Local volatility process
• Ito-Tanaka implies
• Dupire’s formula
23
Local Volatility
• Gives exact calibration to the European volatility surface by construction
0.2
Original
0.18
Shifted
0.16
Implied Volatility
0.14
0.12
0.1 ΔS
0.08
0.06
75 85 95 105 115 125
Strike
26
Heston Model
• Heston process
• Fourier inversion
0.14
0.13
Original
0.12 Shifted
Implied Volatility
0.11
0.1
0.09
0.08
0.07 ΔS
0.06
75 85 95 105 115 125
Strike
29
9.00%
Heston
Market
8.90%
8.80%
8.70%
8.60%
8.50%
8.40%
1W 1M 2M 3M 6M 1Y 2Y
30
8.5
7.5
7
USDJPY
EURUSD
AUDJPY
6.5
6
1W 1M 2M 3M 6M 1Y 2Y 3Y 4Y 5Y
31
0 1W 1M 2M 3M time
• and independent of
33
Stochastic Risk-Reversals
• USDJPY 6 month 25-delta risk-reversals
2.0 2.0
1.8 1.8
1.6 1.6
1.4 1.4
Risk Reversal
1.2 1.2
1.0 1.0
0.8 0.8
0.6 0.6
0.4 0.4
08Nov04
21Nov05
26Nov06
37
• Jacobi process
• Conditions
39
• Correlation structure
40
• Models put forward where there exist multiple time-scales over which volatility
reverts
• For example, have volatility mean-revert quickly to a level which itself is slowly
mean-reverting (Balland)
• Can also have two independent mean-reverting volatility processes with different
reversion rates
43
Double-Heston Model
• Double-Heston process
• Correlation structure
44
Double-Heston Model
• Stochastic volatility-of-volatility
• Stochastic correlation
45
Double-Heston Model
• Pseudo-analytic pricing of Europeans
Double-Heston Parameters
One-Touches
50
One-Touches
51
Variance Swaps
o Product Definition
o Process Definitions
o Variance Swap Term-Structure
o Model Implied Term-Structures
52
• Price process
53
• Double-Heston
• Note the independence of the variance swap term-structure to the correlation and
volatility-of-volatility parameters
55
0.115
0.11
0.105
0.1
0.095
0.09
1M 2M 3M 6M 9M 1Y 2Y
57
Extensions
Multi-Heston Process
• Can always extend Double-Heston to Multi-Heston with any number of uncorrelated
Heston processes
• In fact, using three Heston processes does not significantly improve on the Double-
Heston fits to Europeans and DNTs
60
Summary
• FX markets exhibit certain properties such as stochastic risk-reversals and multiple
modes of volatility reversion
• Barrier products show liquidity - especially DNTs - and their prices are linked to the
forward smile
• The Double-Heston model captures the features of the market and recovers
Europeans and DNTs through calibration
• It also prices One-Touches to within bid/offer spread of SV/LV and exhibits the
required flexibility for modelling the variance swap curve
References
• D. Bates : “Post-’87 Crash Fears in S&P 500 Futures Options”, National Bureau of Economic
Research, Working Paper 5894, 1997
• S. Heston : “A Closed-Form Solution for Options with Stochastic Volatility with Applications to
Bond and Currency Options”, Review of Financial Studies, 1993
• H. Buehler : “Volatility Markets – Consistent Modelling, Hedging and Practical
Implementation”, PhD Thesis, 2006
• M. Joshi : “The Concepts and Practice of Mathematical Finance”, Cambridge, 2003
• J. Andreasen : “Closed Form Pricing of FX Options under Stochastic Rates and Volatility”,
ICBI, May 2006
• P. Balland : “Forward Smile”, ICBI, May 2006
• S. Mikhailov and U. Nogel : “Heston’s Stochastic Volatility, Model Implementation, Calibration
and Some Extensions”, Wilmott, 2005
• A. Chebanier : “Skew Dynamics in FX”, QuantCongress, 2006
• P. Carr and L. Wu : “Stochastic Skew in Currency Options”, 2004
• P. Hagan, D. Kumar, A. Lesniewski and D. Woodward : “Managing Smile Risk”, Wilmott, 2002
• J. Gatheral : “A Parsimonious Arbitrage-Free Implied Volatility Parameterization with
Application the Valuation of Volatility Derivatives”, Global Derivatives & Risk Management,
2004
• dherminder.kainth@rbos.com, nagulan.saravanamuttu@rbos.com
• www.quarchome.org