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Table of Contents
1. Review of risk-neutral valuation and model selection
2. One-dimensional models, yield curves
3. Fitting volatility surfaces
4. The principle of Maximum Entropy
5. Weighted Monte Carlo
Risk-neutral valuation
Future states of the economy or market are represented by
scenarios described with state variables (prices, yields, credit spreads)
X (t ) = [ X 1 (t ), X 2 (t ),..., X n (t )]
Today,
T=0
t0
Scenarios
Time
F ( X (T1 )) F ( X (T2 ))
F ( X (T3 ))
Time
Discount factor
G1 ( X ), G2 ( X )...GM ( X )
trading at (mid-market) prices
C1 , C2 ,...., CM
If we assume no arbitrage opportunities, there exists a pricing
probability measure on the set of future scenarios such that
C j = E P (G j ( X )),
j = 1,2,..., M
Risk-neutral valuation
Consider the target derivative security that we wish to price
Present value of future cash-flows along each scenario (as
specified by term sheet):
Fair Value = E P {G ( X )}
Known prices of cash, forwards and reference derivative securities that trade in
the same asset class
Gives rise to calculation of current risk-premia, to take into account the current
prices of derivatives in the same asset class (needed for relative-value pricing)
Z (T ) = E ( ( X , T ))
P
1 dZ (T )
F (T ) =
Z (T ) dT
AOL #2:
May
Calls
Example
Equity
Options
May 20, 2000 Call Series - AOL $56.500
Sym bol
AOE EH
AOE EV
AOE EI
AOE EW
AOO EJ
AOO EK
AOO EL
AOO EM
AOO EN
AOO EO
AOO EP
AOO EQ
AOO ER
AOO ES
AOO ET
AOO EA
Issue
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
AOL MAY
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
20,
strikes
Intrinsic
Value
16.5
14
11.5
9
6.5
1.5
0
0
0
0
0
0
0
0
0
0
bid
Ask
16.5
14.125
12
9.75
7.875
4.875
2.562
1.375
0.625
0.375
0.125
0.062
0.125
0.062
0.062
0.062
17
14.625
12.5
10.125
8.25
5
2.812
1.5
0.75
0.437
0.25
0.187
0.25
0.125
0.187
0.125
Volum e
26
0
21
0
874
498
2429
2060
1470
463
799
16
10
0
10
0
Open
Interest
1159
0
79
1
2009
13987
58343
48997
15796
14290
8649
6600
1493
1744
596
182
S(T)
Barrier
Barrier Option
S(0)
Need to define a
probability on stock
price paths
95
Im pliedVol
90
Vol.
85
80
75
31.3
32.5
33.8
35
37.5
40
41.3
42.5
43.8
45
46.3
VarSw ap
ImpliedVol 96.6191 94.5071 88.4581 83.9929 81.7033 82.5468 81.4319 80.1212 78.6667 80.7064 78.8035
VarSw ap 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215 87.1215
Strike
Expiration
2/17/01
Expiration
4/21/01
80
70
78
68
76
ImpliedVol
74
66
ImpliedVol
64
72
70
62
68
60
66
58
64
VarSwap
62
56
VarSwap
54
30
.0
0
32
.5
0
35
.0
0
37
.5
0
40
.0
0
42
.5
0
45
.0
0
47
.5
0
50
.0
0
55
.0
0
60
.0
0
60
30.00 32.50 35.00 37.50 40.00 42.50 45.00 47.50 50.00
Expiration
7/21/01
Expiration
1/19/02
62
58
60
56
58
ImpliedVol
54
52
56
50
54
48
52
46
50
44
42
VarSwap
70
.0
0
60
.0
0
50
.0
0
45
.0
0
40
.0
0
35
.0
0
46
40
VarSwap
27
.5
0
35
.0
0
42
.5
0
50
.0
0
57
.5
0
65
.0
0
72
.5
0
80
.0
0
87
.5
0
10
0.
00
48
30
.0
0
ImpliedVol
N=9
Q=37
5/37
6/37
3/37
4/37 3/37
1/37
4/37
11/37
i = 1,.., N
n
i =1
=Q,
i = 1,..., N .
Q!
( p1 ,..., p N ) =
n1!n2 !....nN !
1 n +1/ 2 n
m!
n
e
2
Number of configurations
consistent with p
Stirlings approximation
1
N
( p1 ,..., p N ) Q pi ln = Q pi ln pi
i =1
i =1
pi
N
Q >> N
i
i =1
pi
N
g
i =1
ij
pi = c j
j = 1,..., M
N
1
max pi ln
pi
i =1
g
i =1
ij
pi = c j
j = 1,..., M
Dual Method
Solve
M
min pi ln pi + j pi g ij c j + 0 pi 1
p
j =1
i =1
i =1
ln pi 1 + j g ij + 0 = 0
j =1
1
pi =
exp j g ij ,
Z ( )
j =1
Z ( ) = exp j g ij
i =1
j =1
Price
ATM ImVol
Ticker
Price
ATM ImVol
ABI
17.85
55 GILD
30.05
46
AFFX
17.19
64 HGSI
16.99
84
ALKS
5.79
106 ICOS
23.62
64
AMGN
44.1
40 IDPH
43.31
72
BGEN
35.36
41 MEDI
27.75
82
CHIR
32.03
37 MLNM
11.8
92
CRA
10.2
55 QLTI
9.36
64
DNA
33.27
53.5 SEPR
6.51
84
ENZN
22.09
81 SHPGY
25.2
47
GENZ
21.66
56 BBH
81.5
32
75
66
Im pliedVol
70
Im pliedVol
64
62
65
60
58
BidVol
60
BidVol
56
54
55
52
50
50
60
65
70
75
80
85
90
95
As kVol
50
55
60
65
70
75
80
85
59.10441
60.82449
57.59728
58.64378
57.3007
58.09035
55.77914
53.02048
67.5042
66.93523
67.08418
64.42438
60.53124
57.80586
55.33041
55.29034
ImpliedVol
BidVol
63.23
64.55163
65.02824
62.43146
58.36119
56.02341
54.08097
51.39689
BidVol
48.36397
55.99293
54.16418
56.42753
55.39614
56.75332
53.91233
48.60503
AskVol
71.59664
69.29996
69.1395
66.41618
62.68222
59.54988
56.54053
58.64633
AskVol
66.93634
65.38443
60.98989
60.86071
59.19764
59.41203
57.57386
56.72775
ImpliedVol
VarSw ap
VarSw ap
VarSw ap
As kVol
VarSw ap
Im pliedVol
Needed:
80
75
70
BidVol
65
60
55
50
53.4
56.6
58.4
60
65
70
75
80
85
90
As kVol
ImpliedVol 74.2145 73.3906 71.4854 68.4688 68.7068 64.2811 65.1807 64.3257 62.4619 63.1047
BidVol
57.9276
60.658
AskVol
VarSw ap
78.353
20-dimensional stochastic
process
fits option data (multiple expirations)
martingale property
i = r di
ensures martingale
property
1-Dimensional Problems
Dupire: local volatility as a function of stock price = (S, t )
Hull-White, Heston: more factors to model stochastic volatility
Rubinstein, Derman-Kani: implied ``trees
These methods do not generalize to higher dimensions.
They are ``rigid in terms of the modeling assumptions that can be made.
dX = dW + B dt
time
dX = dW + B dt
p1
p2
p3
time
Example 1: Discrete-Time
Multidimensional Markov Process
Modeled after a diffusion
N
(i )
(i )
(i )
(i )
S n +1 = S n 1 + n ij n, j t + n t
j =1
n , j = i.i.d. normals
Correlations estimated from econometric analysis
Vols are ATM implied or estimated from data
Time-dependence, seasonality effects, can be incorporated
Example 2: Multidimensional
Resampling
S ni = historical data matrix
X ni =
S ni S ( n 1)i
S ( n 1) i
Yni =
n (sample size )
X ni
(X
m =1
mi
Xi
R(n) can be
uniform or have
temporal correlation
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
ad
p
AM
ZN
BR
C
M
C
PQ
D
EL
L
EM
C
FD
C
IB
M
IN
TU
JN
P
R
M
O
T
M
U
O
R
CL
PM
TC
SL
R
SU
N
W
TX
N
YH
O
O
Q
QQ
STD
Simulation consists of
sequence of random
draws from standardized
empirical distribution
-0.5
-1
-1.5
-2
IN
TU
JN
P
R
M
O
T
M
U
O
R
C
PM L
TC
SL
SU R
N
W
TX
YH N
O
O
Q
Q
Q
-2.5
-3
ad
AM p
ZN
BR
C
M
C
PQ
D
EL
L
EM
C
FD
C
IB
M
std
0.5
0
g ij = e
rT j
max S i ,Tj j K j ,0
a
C1 g11
... = ...
C g
M M1
Repricing condition
g12
...
...
p1
... ... g1N
p2
... ... ...
...
... ... g MN
pN
C j = E P (g j (S )),
j = 1,2,..., M
Maximum-Entropy Algorithm
H ( p ) = pi log pi = D( p || u )
i =1
1
1
u = ,...,
N
N
Algorithm: solve
"
pi = pi =
exp j g ij ,
Z ( )
j =1
i = 1,2,..., N
Unknown parameters
M
Z ( ) = exp j g ij
i =1
j =1
Boltzmann-Gibbs partition
function
Calibration Algorithm
How do we find the lambdas?
Minimize in lambda
M
W ( ) = log Z ( ) j C j
j =1
W is a convex function
The minimum is unique, if it exists
W is differentiable in C, lambda with explicit gradient
Use L-BFGS Quasi-Newton gradient-based optimization routine
Boltzmann-Gibbs formalism
W ( )
= E P (G j ( X )) C j
j
Gradient=difference between
market px and model px
2W ( )
= E P (G j ( X )Gk ( X )) C j Ck = Cov P (G j ( X ), Gk ( X ))
j k
Hessian=covariance of
cash-flows under pricing measure
Numerical optimization with known gradient & Hessian also possible
Least-Squares Version
2
= g ij pi C j = E P (g j (S )) C j
j =1 i =1
j =1
2
min p H ( p ) + 2
2
2
min ln Z ( ) + j C j +
2
j =1
j =1
2
j
Equivalent to adding
quadratic term to
objective function
Sensitivity Analysis
h( X ) = payoff function of ``target security' '
E P (h( X )) = model value of
"
E P (h( X )) E P (h( X )) k
=
C j
k
C j
C
= Cov (h( X ), g k ( X ))
k
P
= Cov
1
kj
1
jk
Price-Sensitivities= Regression
Coefficients
Solve LS problem:
min pi h( X i ) j G j ( X i )
,
i =1
j =1
Uncorrelated to gj(X)
h( X ) = + j g j ( X ) + ( X )
j =1
)(
g (S ) = St1 ,..., St N St N +1 S t N
Martingale constraint :
E P (g (S )) = 0 for all