Topics in Asset Pricing Homework 3

Students:
Jos Ignacio Carter Fabrizio Monroy Ral Pefaur Moiss Valdebenito

Professor:
Pablo Castaeda

Date:
October 24, 2013

We changed to the market model Smile Adjustment with Sticky Moneyness, from the paper of Alexander & Kaeck. Given that we need to simulate 10,000 samples of the P&L of a rolling short position, we created the following scenario: We are short in a Call, and five days later, we want to close that position. At the first day, we also build the hedging portfolio, consisting in an opposite position on another Call (which will have different nature: it may change on its maturity, and/or its strike price, the important thing is that this hedging Call will never be the same as the one we are short), and also a position in the underlying asset. Also, we do not want to recalculate the hedge daily; we will just have the first position, make the hedge, and see the Profits & Losses at day 5. Given that we want 10,000 simulations for the P&L of out hedge, we will use the contracts with maturities 1Y, 6M and 3M, with each of the 7 different deltas of the smile curve for each maturity, giving that 21 positions to hedge per day, during 588 days (because we have information for 593 days, but we need 5 to close the position). The hedging portfolio will be: And, in t=t:

X 0 = C0 = ( C0 ! " F 0 ! " ## 0 ) + " F 0 + " ## 0

X t = C0 = ( C0 ! " ## 0 ) ert + " F e! rT !t F1T !t ! F0T + " ## t

We see that at t=0, the Call we are trying to hedge has the same value as the portfolio, but not necessarily the same at t=t. The portfolio gains value over time; the money market account, the forward contract, and the option we are using to hedge change their values. There appears a problem: because we want to close the position at day 5, we need to see the value of the option we are trying to hedge at that time; this means, we have to get the value of an option that is missing, for example 55 days (if it was originally a 60 day Call). This also happens to the discount factors, the implied volatility, and the forward price; this is information we do not have, so we will have to interpolate it.

There was a change to be made. Given that in FX trading, the standard is to use Forward prices rather than Spot Prices, everything is in terms of F. Plus, the Sticky Moneyness model consists in using a term call Moneyness, which is:
m= log( K / F )

we use this term given that the Implied Volatility Surface is a function of the moneyness. This also means that we will no longer work with Strikes, but with Moneyness values. To adjust the smile, we need:
! adj ( m | F ) = ! BSM ( m | F ) + " BSM ( m | F ) IVF ( m | F )
! adj ( m | F ) = ! BSM ( m | F ) + " BSM ( m | F ) IVFF ( m | F ) + 2# BSM ( m | F ) IVF ( m | F ) + $ BSM ( m | F ) IVF ( m | F )
2

This means that for the hedging, we need to calculate the Greeks: Delta, Gamma, Vega, Vanna and Volga. The Sticky Moneyness delta has:
IVF ( m | F ) = ! 1 F " IVm ( m | F )

And to compute IVm , we parameterize the implied volatility:

IV ( m,! ) = ! 0 + ! 1m + ! 2 m2 + ! 3m3

The problem with out hedging strategy is that the Greeks have to be calculated again, given that now we are using moneyness instead of K, and Forward Price instead of Spot.

Results
First, we needed to calibrate the alphas of the cubic function of moneyness to have the values of each of them, for every day.1

Code Tarea 3.m, Local Calibration

The idea is to compare our results with the ones that will be obtained if using the normal Black Scholes Merton model. The P&L, for 10,000 different hedgings, are as follows:

Our model is centered in 0, but it has some extreme values up to -2000 and 2000, that makes us think something is not correct. Also, we can see the BSM model has more reasonable values. The mean in P&L of our model is -0.464, and in BSM is 0.1704. And of course, the main difference is in the standard deviation: 27.18 in our model vs. 0.45 in BSM. This means that BSM model outperforms the one we created, but we think that something must be wrong for this to happen. Our main suspicion is that we may have derivate wrong one of the Greeks, given that we had to recalculate everything again in terms of moneyness and forward price.