Skew Modeling

Bruno Dupire
Bloomberg LP
bdupire@bloomberg.net
Columbia University, New York
September 12, 2005
I. Generalities
 Market Skews

Dominating fact since 1987 crash: strong negative skew on

Equity Markets σ impl

K
Not a general phenomenon

Gold: σ impl FX: σ impl

K K

We focus on Equity Markets

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 Skews
• Volatility Skew: slope of implied volatility as a
function of Strike
• Link with Skewness (asymmetry) of the Risk
Neutral density function ϕ ?

Moments Statistics Finance

1 Expectation FWD price
2 Variance Level of implied vol
3 Skewness Slope of implied vol
4 Kurtosis Convexity of implied vol

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 Why Volatility Skews?
• Market prices governed by
– a) Anticipated dynamics (future behavior of volatility or jumps)
– b) Supply and Demand

σ impl Sup
ply
and
Market Skew
Dem
and
Th. Skew
K

• To “ arbitrage” European options, estimate a) to capture

risk premium b)
• To “arbitrage” (or correctly price) exotics, find Risk
Neutral dynamics calibrated to the market

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 Modeling Uncertainty
Main ingredients for spot modeling
• Many small shocks: Brownian Motion
(continuous prices) S

• A few big shocks: Poisson process (jumps)

S

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 2 mechanisms to produce Skews (1)

• To obtain downward sloping implied volatilities

σimp

– a) Negative link between prices and volatility

• Deterministic dependency (Local Volatility Model)
• Or negative correlation (Stochastic volatility Model)

– b) Downward jumps

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 2 mechanisms to produce Skews (2)
– a) Negative link between prices and volatility

S1 S2
– b) Downward jumps

S1 S2

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Leverage and Jumps
 Dissociating Jump & Leverage effects
t0 t1 t2

x = St1-St0 y = St2-St1

• Variance : (x + y) = x + 2xy+ y
2 2 2

Option prices FWD variance

∆ Hedge

• Skewness : (x + y)3 = x3 + 3x2 y + 3xy2 + y3

Option prices Leverage
∆ Hedge
FWD skewness

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 Dissociating Jump & Leverage effects

Define a time window to calculate effects from jumps and

Leverage. For example, take close prices for 3 months

∑ (δS )
3
• Jump: ti
i

∑ (S )( )
− S t1 δS ti
2
• Leverage: ti
i

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 Dissociating Jump & Leverage effects

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 Dissociating Jump & Leverage effects

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Break Even Volatilities
 Theoretical Skew from Prices

?
=>
Problem : How to compute option prices on an underlying without
options?
For instance : compute 3 month 5% OTM Call from price history only.
1) Discounted average of the historical Intrinsic Values.
Bad : depends on bull/bear, no call/put parity.
2) Generate paths by sampling 1 day return recentered histogram.
Problem : CLT => converges quickly to same volatility for all
strike/maturity; breaks autocorrelation and vol/spot dependency.
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 Theoretical Skew from Prices (2)

3) Discounted average of the Intrinsic Value from recentered 3 month

histogram.
4) ∆-Hedging : compute the implied volatility which makes the ∆-
hedging a fair game.

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 Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history? S
Example: K
ST 1

3 month daily data

T1 t T2
1 strike K = k ST1
– a) price and delta hedge for a given σ within Black-Scholes
model
– b) compute the associated final Profit & Loss: PL(σ )
– ( ) ( ( ))
c) solve for σ k / PL σ k = 0
– d) repeat a) b) c) for general time period and average
– e) repeat a) b) c) and d) to get the “theoretical Skew”

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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 Theoretical Skew
from historical prices (4)

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Barriers as FWD Skew trades
 Beyond initial vol surface fitting

• Need to have proper dynamics of implied volatility

– Future skews determine the price of Barriers and

OTM Cliquets
– Moves of the ATM implied vol determine the ∆ of
European options

• Calibrating to the current vol surface do not impose

these dynamics

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 Barrier Static Hedging

Down & Out Call Strike K, Barrier L, r=0 :

• With BS: DOCK ,L = CK − K L PL2
K
If S t = L ,unwind hedge, at 0
cost K
L2
K
L
2

K
L
If not touched, IV’s are equal K L K
L

• With normal model

DOCK , L = C K − P2 L − K
2L-K
dS = σdW 1 L K

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 Static Hedging: Model Dominance
• Back to DOCK , L
L
K

• An assumption as the skew at L corresponds to

an affine model
dS = (aS + b )dW (displaced LN)
• DOCK ,L priced as in BS with shifted K and L gives
new hedging PF which is >0 when L is touched if
Skew assumption is conservative

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 Skew Adjusted Barrier Hedges
dS = (aS + b )dW
aK + b
DOC K , L ↔ CK − PaL2 +b (2 L − K )
aL + b aK + b

⎛ ⎞ aK + b
↔ C K − (L − K )⎜ 2 Dig L +
a
UOC K , L CL ⎟ − C aL2 +b (2 L − K )
⎝ aL + b ⎠ aL + b aK + b

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Local Volatility Model
 One Single Model
• We know that a model with dS = σ(S,t)dW
would generate smiles.
– Can we find σ(S,t) which fits market smiles?
– Are there several solutions?

ANSWER: One and only one way to do it.

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 The Risk-Neutral Solution
But if drift imposed (by risk-neutrality), uniqueness of the solution

Risk
Diffusions Neutral
Processes

sought diffusion
Compatible
(obtained by integrating twice
with Smile
Fokker-Planck equation)

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 Forward Equations (1)
• BWD Equation:
price of one option C (K 0 ,T0 ) for different (S, t )
• FWD Equation:
price of all options C (K , T ) for current (S 0 ,t0 )
• Advantage of FWD equation:
– If local volatilities known, fast computation of implied
volatility surface,
– If current implied volatility surface known, extraction of
local volatilities,
– Understanding of forward volatilities and how to lock
them.

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 Forward Equations (2)
• Several ways to obtain them:
– Fokker-Planck equation:
• Integrate twice Kolmogorov Forward Equation
– Tanaka formula:
• Expectation of local time
– Replication
• Replication portfolio gives a much more financial
insight

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 Fokker-Planck

• If dx = b( x, t )dW
∂ϕ 1 ∂ 2 (b 2ϕ )
• Fokker-Planck Equation: =
∂t 2 ∂x 2
∂ 2C
• Where ϕ is the Risk Neutral density. As ϕ =
∂K 2
2 ⎛ ∂C ⎞
⎛ ∂ 2C ⎞ 2⎛ 2 ∂ C ⎞
2

∂ ⎜ ⎟ ∂⎜⎜ 2 ⎟⎟ ∂ ⎜⎜ b ⎟
2 ⎟
⎝ ∂t ⎠ = ⎝ ∂K ⎠ = 1 ⎝ ∂K ⎠
∂x 2 ∂t 2 ∂x 2

• Integrating twice w.r.t. x: ∂C b2 ∂2C

=
∂t 2 ∂K 2
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 Volatility Expansion

•K,T fixed. C0 price with LVM σ 0 ( S t , t ) : dS t = σ 0 ( S t , t ) dWt

•Real dynamics: dSt = σt dWt

∂ ∂
T 2 T
C 1 C0 2
•Ito ( ST − K ) = C0 ( S 0 ,0) + ∫ dS + ∫ σ σ
+ 0
( − 2
0 ( S t , t )) dt
∂S 2 0 ∂S 2 t
0

• Taking expectation:
1
([ ] )
C ( S 0 ,0) = C0 ( S 0 ,0) + ∫∫ Γ0 ( S , t ) Ε σ t2 St = S − σ 02 ( S , t ) ϕ ( S , t )dSdt
[ ]
2
•Equality for all (K,T) Ù Ε σ t S t = S = σ 0 ( S , t )
2 2

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 Summary of LVM Properties

Σ0 is the initial volatility surface

• σ (S,t ) compatible with Σ0 ⇔σ = local vol

•σ (ω ) compatible with Σ ⇔ E[σ

0 2 ST = K ] = (local vol)²

• σ̂ k,T deterministic function of (S,t) (if no jumps)

⇔ future smile = FWD smile from local vol

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Stochastic Volatility Models
 Heston Model
⎡ dS
⎢ S = µ dt + v dW
⎢
( )
⎢⎣dv = κ v 2 ∞ − v dt + η v dZ dW , dZ = ρ dt

Solved by Fourier transform:

FWD
x ≡ ln τ =T −t
K
C K ,T ( x, v,τ ) = e x P1 ( x, v,τ ) − P0 ( x, v,τ )

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 Role of parameters
• Correlation gives the short term skew
• Mean reversion level determines the long term
value of volatility
• Mean reversion strength
– Determine the term structure of volatility
– Dampens the skew for longer maturities
• Volvol gives convexity to implied vol
• Functional dependency on S has a similar effect
to correlation

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 Spot dependency

2 ways to generate skew in a stochastic vol model

1) σ t = xt f (S , t ), ρ (W , Z ) = 0
2) σρ (W , Z ) ≠ 0 σ

S0 ST ST

S0

-Mostly equivalent: similar (St,σt ) patterns, similar

future
evolutions
-1) more flexible (and arbitrary!) than 2)
-For short horizons: stoch vol model Ù local vol model
+ independent noise on vol.
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 SABR model
• F: Forward price
β
dF = F σ t dW
dσ
= α dZ
σ

• With correlation ρ

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Smile Dynamics
 Smile dynamics: Local Vol Model (1)
• Consider, for one maturity, the smiles associated
to 3 initial spot values

Skew case Local vols

Smile S −
Smile S 0
Smile S +

S − S0 S + K

– ATM short term implied follows the local vols

– Similar skews

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 Smile dynamics: Local Vol Model (2)

• Pure Smile case

Local vols

Smile S +
Smile S −

Smile S 0

S− S0 S+ K

– ATM short term implied follows the local vols

– Skew can change sign

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 Smile dynamics: Stoch Vol Model (1)
Skew case (r<0) Local vols

σ Smile S −
Smile S 0
Smile S +

S − S0 S+ K

- ATM short term implied still follows the local vols

(E [σ 2
T ]
S T = K = σ 2 (K , T ) )
- Similar skews as local vol model for short horizons
- Common mistake when computing the smile for another
spot: just change S0 forgetting the conditioning on σ :
if S : S0 → S+ where is the new σ ?
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 Smile dynamics: Stoch Vol Model (2)
• Pure smile case (r=0)

σ
Local vols
Smile S − Smile S +

Smile S 0

S− S0 S+ K

• ATM short term implied follows the local vols

• Future skews quite flat, different from local vol
model
• Again, do not forget conditioning of vol by S

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 Smile dynamics: Jump Model
Skew case
Local vols

Smile S −

Smile S 0
Smile S +

S− S0 S + K

• ATM short term implied constant (does not follows the

local vols)
• Constant skew
• Sticky Delta model

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 Smile dynamics: Jump Model
Pure smile case

Local vols

Smile S 0
Smile S − Smile S +

S− S0 S+ K

• ATM short term implied constant (does not follows the

local vols)
• Constant skew
• Sticky Delta model

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 Smile dynamics
Weighting scheme imposes
some dynamics of the smile for S1
a move of the spot: S0 K
For a given strike K,
S↑ ⇒ σ∃K ↓
(we average lower volatilities) t
Smile today (Spot St) 26

&
Smile tomorrow (Spot St+dt) 25.5

in sticky strike model 25

24.5
Smile tomorrow (Spot St+dt)
if σATM=constant 24

23.5
Smile tomorrow (Spot St+dt)
in the smile model
St+dt St

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 Volatility Dynamics of different models

• Local Volatility Model gives future short term

skews that are very flat and Call ∆ lesser than
Black-Scholes.
• More realistic future Skews with:
– Jumps
– Stochastic volatility with correlation and mean-
reversion
• To change the ATM vol sensitivity to Spot:
– Stochastic volatility does not help much
– Jumps are required

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ATM volatility behavior
 Forward Skews

In the absence of jump :

model fits market ⇔ ∀K , T E[σ T2 ST = K ] = σ loc
2
(K ,T )
This constrains
a) the sensitivity of the ATM short term volatility wrt S;
b) the average level of the volatility conditioned to ST=K.

a) tells that the sensitivity and the hedge ratio of vanillas depend on the
calibration to the vanilla, not on local volatility/ stochastic volatility.
To change them, jumps are needed.
But b) does not say anything on the conditional forward skews.

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 Sensitivity of ATM volatility / S

At t, short term ATM implied volatility ~ σt.

∂σ t
2
As σt is random, the sensitivity is defined only in average:
∂S
∂σ loc
2
(S , t )
Et [σ 2
t +δt − σ Sδt = St + δS ] = σ ( St + δS , t + δt ) − σ ( St , t ) ≈
2 2 2
⋅ δS
∂S
t loc loc

In average, σ ATM
2
follows σ loc
2
.
Optimal hedge of vanilla under calibrated stochastic volatility corresponds to
perfect hedge ratio under LVM.

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 Market Model of Implied Volatility
• Implied volatilities are directly observable
• Can we model directly their dynamics? (r = 0)
⎧dS
⎪⎪ S = σ dW1
⎨
⎪dσˆ = α dt + u dW + u dW
⎪⎩ σˆ 1 1 2 2

where σ̂ is the implied volatility of a given C K ,T

• Condition on σˆ dynamics?

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 Drift Condition
• Apply Ito’s lemma to C(S,σˆ , t )
• Cancel the drift term
• Rewrite derivatives of C(S,σˆ , t )
gives the condition that the drift α of dσˆ must satisfy.
σˆ
For short T, we get the Short Skew Condition (SSC):
2 2
⎛ K ⎞ ⎛ K ⎞
C ( S ,σ ,̂ t)

t →T

σˆ = ⎜ σ + u1 ln( ) ⎟ + ⎜ u2 ln( ) ⎟
2

⎝ S ⎠ ⎝ S ⎠
K
close to the money: σˆ ~ σ + u1 ln( )
2

S
Î Skew determines u1

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 Optimal hedge ratio ∆H

• C ( S , σˆ , t ) : BS Price at t of Call option with

strike K, maturity T, implied vol σ̂

• Ito: dC ( S , σˆ , t ) = 0dt + CS dS + Cσˆ dσˆ

• Optimal hedge minimizes P&L variance:
dC.dS dσˆ .dS
∆ =
H
2
= CS + Cσˆ 2
(dS ) (dS ) Implied Vol
BS Vega sensitivity
BS Delta

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 Optimal hedge ratio ∆H II
dσˆ .dS
∆ = CS + Cσˆ
H

(dS ) 2
⎧ dS
⎪⎪ S = σdW1
With ⎨
⎪ dσˆ = αdt + u dW + u dW
⎪⎩ σˆ 1 1 2 2

dσˆ .dS u1σS (dW1 ) 2 u1σˆ

= =
(dS ) 2
(σS ) (dW1 )
2 2
σS

Î Skew determines u1, which determines ∆H

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Smile Arbitrage
 Deterministic future smiles
It is not possible to prescribe just any future
smile
If deterministic, one must have
C K ,T (S 0 , t 0 ) = ∫ ϕ (S 0 , t 0 , S , T1 ) C K ,T (S , T1 )dS
2 2

Not satisfied in general

K
S0

t0 T1 T2

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 Det. Fut. smiles & no jumps
=> = FWD smile
If ∃(S , t , K , T ) / VK ,T (S , t ) ≠ σ (K , T ) ≡ lim σ imp (K , T , K + δK , T + δT )
2 2
δK → 0
δT → 0
stripped from Smile S.t
K
Then, there exists a 2 step arbitrage:
Define ∂ 2C S0
2
( (K , T ) − V (S , t )) ∂K (S , t , K , T )
PL t ≡ σ K ,T 2 S
(
At t0 : Sell PL t ⋅ Dig S − ε ,t − Dig S + ε ,t ) t0 t T
At t: if S ∈ [S − ε , S + ε ] buy
2
CS K, T , sell σ 2
(K , T )δ K ,T
t 2
K
gives a premium = PLt at t, no loss at T

Conclusion: VK ,T (S , t ) independent of (S , t ) = VK ,T (S0 , t0 ) = σ 2 (K , T )

from initial smile

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 Consequence of det. future smiles

• Sticky Strike assumption: Each (K,T) has a fixed σ impl ( K , T )

independent of (S,t)
• Sticky Delta assumption: σ impl ( K , T ) depends only on
moneyness and residual maturity

• In the absence of jumps,

– Sticky Strike is arbitrageable
– Sticky ∆ is (even more) arbitrageable

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 Example of arbitrage with Sticky Strike
Each CK,T lives in its Black-Scholes (σ impl ( K , T ) )world
C1 ≡ C K 1 ,T1 C 2 ≡ C K 2 ,T2 assume σ 1 > σ 2
P&L of Delta hedge position over dt:

δ PL (C 1 ) = 1
2
((δ S ) − σ S δ t ) Γ
2
1
2
1

δ PL (C 2 ) = 1
2
((δ S ) − σ S δ t ) Γ
2
2
2
2
Γ1C 2
Γ2 C 1
Γ1Γ2 2 2
δ PL (Γ1C 2 − Γ2 C 1 ) =
2
(
S σ 1 − σ 22 δ t > 0 ) S t1 S t + δt
(no Γ , free Θ )
! If no jump

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 Arbitrage with Sticky Delta

• In the absence of jumps, Sticky-K is arbitrageable and Sticky-∆ even more so.
• However, it seems that quiet trending market (no jumps!) are Sticky-∆.
In trending markets, buy Calls, sell Puts and ∆-hedge.

Example:
K1 St
PF ≡ C K 2 − PK1
K2

σ 1 ,σ 2
S PF
∆-hedged PF gains
VegaK > Vega K
2 1 from S induced
σ 1 ,σ 2 volatility moves.
S PF
VegaK < Vega K
2 1

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 Conclusion
• Both leverage and asymmetric jumps may generate skew
but they generate different dynamics

• The Break Even Vols are a good guideline to identify risk

premia

• The market skew contains a wealth of information and in

the absence of jumps,
– The spot correlated component of volatility
– The average behavior of the ATM implied when the spot moves
– The optimal hedge ratio of short dated vanilla
– The price of options on RV

• If market vol dynamics differ from what current skew

implies, statistical arbitrage
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