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Changrong Cui and David Frank Quantitative Research and Development, Equities Team June 21, 2011 Version 3.6
Introduction
This document describes the construction of the equity volatility surfaces shown in the function OVDV. Volatility surface construction involves data ltering, implied forward and implied dividend calculation, and option data tting. We discuss each of these steps in separate sections below. In the option data tting step, our method is based on the mixture of lognormal distributions. At the end of this document we present the connection between the lognormal mixture method and stochastic volatility models.
Data Filtering
We determine whether to use bid/ask or settlement data as follows: 1. For each maturity, the bid/ask data at the maturity is deemed to be good if at least 10% of the quotes and at least 3 options have valid bid/ask prices. 2. Use bid/ask data to build the surface if at least 10% of maturities or at least 3 maturities have good bid/ask data; otherwise use exchange settlement data (last). The data is then ltered as follows: 1. Filter out maturities that are too short. Currently the threshold is 7 days. 2. Eliminate in-the-money options (we use only out-of-the-money options for the surface except for the implied forward computation). 3. Eliminate last data older than 0.001 years. 4. Eliminate bad price data with too small bid/ask/last prices or too wide bid/ask spreads. 5. To ensure monotonicity of prices, we take the longest increasing/decreasing subsequence from call/put prices at each maturity and throw out the remainder. 6. At a given maturity, we calculate implied volatilities from mid prices (when using bid/ask) or from settlement prices. Then we compare each implied volatility to the median of all implied volatilities. We eliminate those strikes whose implied volatilities are outside a certain range. Currently the range is taken as 0.2 to 5.0 times the median volatility. 7. After all valid strikes at all maturities have been found, we check the number of strikes at each maturity. Again, we compare the number of strikes of each individual maturity to the median value across all maturities. If the number of strikes is below 20% of the median, we lter out this maturity. 2
Let Fi denote the forward at time ti . We will imply out the dividend amounts in cash di and in stock yi paid at ti , as well as continuous yield q applying over the period (0, T ). We do this using the following strategy: from 1. Imply d Ft = F0 e 2. Imply q from F0 e 3. Imply d from FT = F0 e(rq)T d 4. For i = 1, . . . , n do (a) Let di = d
d i y d i + i (rq )T rT n i=1 n i=1 n i=1
er(T ti )
= F0 e
rT
q r (T ti ) i e
e(rq)(T ti )
(b) Let Fi = Fi1 e(rq)(ti ti1 ) d (c) Imply yi from Fi = Fi1 e(rq)(ti ti1 ) (1 yi ) di
pl (T ) lognormalpdf (S, l (T )F (T ), l (T ))
OVDV Equity Volatility Surface N is the number of lognormals, F (T ) is the forward price, pl (T ) is the time-dependent weight of the l-th lognormal, l (T ) is the time-dependent multiplicative means of the l-th lognormal, l (T ) is the time-dependent deviation of the l-th lognormal. We require pl (T ) > 0, l (T ) > 0, l (T ) > 0 l pl (T ) 1. If the sum of weights is less than 1, then then there is a point mass at zero which represents a probablity of default. A strictly positive default probability could help to t a high skew in the low strike range, which is common in equities market. l pl (T )l (T ) = 1. The weighted sum of means is the expectation of ST and it must be equal to the forward price. Now, the price of a European call option with maturity T and strike K can be written as N pl (T ) blsprice(l (T )S0 , K, r, T, l (T )/ T ) C (T, K ) =
l=1
and we can get the implied volatility at any point using this call price formula, where blsprice(S, K, r, T, ) is the Black-Scholes price of a call option with spot S , strike K , risk-free rate r, time to expiration T and volatility . Figure 1 shows an example of the mixture of two lognormals. The mixed lognormal has larger density in the middle range and fatter tail as shown in Figure 2. Also, the mixed lognormal produces the volatility smile as shown in Figure 3. It is difcult to have a perfect answer for the choice of N , the number of lognormals. If N is too small, the volatility smile would not have enough exibility to t the market data; if N is too large, there will be an overtting issue. In practice, we choose N = 4 and use a more rigid structure for the four lognormals when there are not a sufcient number of valid options. We now describe the optimization which nds the mixed lognormal parameters best tting the market prices. The target of our non-linear least square problem is European option prices. If the market options are not European-style exercise, then we have already converted the market prices to European prices using the methodology described in the section Implied Forwards and Dividends. The optimization 5
0.5
0.5
1.5
2.5
Figure 1. Density functions for mixed lognormals and one lognormal. N = 2, 1 = 0.95, 2 = 1.05, 1 = 0.40, 2 = 0.20, p1 = p2 = 0.5, T = 1, F = 1. The deviation of the single lognormal is chosen to match the variance of ST in the mixed lognormal.
Density Functions Tail 0.05 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 2 2.2 2.4 2.6 2.8 3 Mixed Lognormal Lognormal
0.38
0.36
0.34
0.32
0.3
0.5
1.5
2.5
OVDV Equity Volatility Surface is done maturity-by-maturity, except that if the optimizations among different market maturities are done completely independently, there may be calendar arbitrage. To control that, we use constraints on the lognormal parameters of different maturities, for example, for each l = 1, , N ,
mkt mkt mkt 0 < l (T1 ) < l (T2 ) < < l (Tn ) mkt
With this constraint, we can build an increasing curve l (T ) from market maturity points. Similarly, we can have the other two classes of curves l (T ) and pl (T ), l = 1, , N . Having constructed the curves pl (T ), l (T ) and l (T ), we can then compute the surface volatility given any strike and maturity by interpolating or extrapolating the curves to determine the parameters at the required point, computing the weighted sum of Black-Scholes prices, and inverting to get the required implied volatility. Having the mid implied volatility, we calculate the bid/ask volatility spread using linear interpolation and at extrapolation in strike dimension and Hermite interpolation and at extrapolation in maturity dimension.
where
2
1 = T
T 2 (1 2 )t dt
Let
) ( t 1 2 t 2 t = exp s dZs s ds 2 0 0
2 at each realization of {Y }. When the number of lognormals goes to volatility t innity, the discrete lognormals will converge to this model.
References
[Brigo and Mercurio (2002)] D. Brigo and F. Mercurio (2002), Lognormal-Mixture Dynamics and Calibration to Market Volatility Smiles, International Journal of Theoretical & Applied Finance 5(4), 427-446. [Fouque, Papanicolaou and Sircar (2000)] J-P. Fouque, G. Papanicolaou, K. R. Sircar (2000), Derivatives in Financial Markets with Stochastic Volatility, Cambridge University Press
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