Professional Documents
Culture Documents
Peter Jckel
a
First version: 28th July 2012
This version: 28th July 2012
Abstract
In practice, it is not uncommon for X to be the market price of a standard investment asset such as an
equity share, denominated in its domestic currency
DOM, and for Y to be an FX rate that converts the
nal investment asset value to a target currency TAR.
As a consequence of the natural direction of the FX
rate, i.e., DOMTAR, meaning the value of one DOM
currency unit expressed in units of TAR, the valuation of a composite option may also incur a quanto
eect since the asset X and the FX rate DOMTAR
cannot be martingales in the same measure, and this
has to be taken into account. For the purpose of this
article, however, we shall assume that all involved
underlyings are martingales in the same measure. In
practice, this may mean that we have to determine
an eective quanto forward for the asset X in the target currency TAR by other means of approximation
prior to being able to commence with our eective
geodesic strike procedure. We shall return to this
point at the end of section 3.
Basket options are, conventionally, derivatives
with a payo of the form
Introduction
( [
K])+ .
(2.2)
i wi Xi (T )
( [
i wi X
(Ti ) K])+ .
(2.4)
( [(X(T ) Y (T )) K])+
(2.5)
with = 1 for calls and puts, based on two underlyings X and Y observed on the expiry date T Tpay . for two underlyings X and Y .
By allowing the subscript i on an observation index
negative as well as positive, it is clear that all of bas- relating to the dispersion matrix A according to
ket, Asian, and spread options take on the form of
C =AA .
(3.5)
an arithmetic average option
(2.6) The approximation of eective geodesic strikes is now
to nd a set of logarithmic shift coecients , which
Equally, it is evident that both composite and geo- relates to the eective strike for underlying #i as
metric basket options appear as a geometric average
Ki = Xi ei ,
(3.6)
option
wi
( [ i Xi K])+ .
(2.7)
such that the multivariate probability density of
Subsequently, we will therefore concentrate on these under the joint normal law with
two generic cases: geometric and arithmetic average
options.
=C
(3.7)
( [
i wi Xi
K])+ .
Geodesic strikes
f (K ) = K .
The formal derivation of the procedure for the calculation geodesic strikes in [ABOBF02] involves concepts of projection onto an eective local volatility
representation of a basket process for large deviations, as well as Varadhans geodesic theorem [Var67],
and is rather technical. In this document, we shall
attempt to obtain a similar result with a somewhat
less rigorous, though tractable, argument, bearing in
mind that the sole purpose of the exercise is to arrive at a set of suitably chosen eective strikes for
the lookup of implied volatilities from the underlyings implied volatility smiles. These volatilities are
then to be used in whatever near-vanilla approximation that is chosen for the respective target product.
We emphasize that it is clear that this process cannot
possibly arrive at a sophisticated exotic product pricing framework. Instead, it merely is intended to give
a procedure that suces for the simplistic, but very
fast, valuation of some near-vanilla products whilst
preserving some sensible consistency conditions.
The starting point is that all of the involved
stochastic nancial observables X are governed by
a joint log-normal law, and that there is a critical
level K for a function f () of the nancial observables, identied by the fact that the payout is of the
form
( (f (X) K))+ .
(3.1)
aij zj
() :=
e 2
C 1
(2)n |C|
(3.10)
(3.11)
with
= A z .
(3.12)
As we shall see below, it turns out that the eective strikes themselves depend on (implied) volatilities. This makes the task of eective geodesic strike
calculation ultimately an implicit problem, since we
need the eective strikes to be able to look up the
implied volatilities in the rst place. In practice, we
resolve this by the approximation that all volatilities that show up in the eective strike formul are
to be taken as at-the-forward implied volatilities. In
this context, we recall that we mentioned at the end
of the rst paragraph in section 2 that, when some
of the underlyings require translation into the target
valuation measure, an approximation for this translation of forward and implied volatility smile has to
be employed separately and prior to the invocation of
the eective geodesic strike procedure. When choosing the quanto-translation procedure, it is useful to
bear in mind that the subsequent geodesic strike selection is only an approximation for the sake of analytic tractability for a range of near-vanilla products,
(3.2)
with
X= X ,
(3.9)
with
Xi = Xi e 2 cii +
(3.8)
(3.3)
3.1
Ki = Xi ei
with
i :=
Xiwi .
(X) =
ln
XY
X (X +XY Y )
2
2
X +2X XY Y +Y
KY = Y e
ln
XY
Y (Y +XY X )
2
2
X +2X XY Y +Y
(3.25)
lim KX =
(3.14)
Y 0
(3.26)
which is consistent with the exact plain vanilla op(3.15) tion we arrive at in this limit for a composite option,
and we obtain of course the symmetric equivalent for
X 0. When correlation is zero, the log-moneyness
of the composite option translates to log-moneyness
(3.16) of the underlyings as a function of the log-volatilityratio
:= 2 ln(X /Y )
(3.27)
(3.17) according to the logistic functions
with
Xiwi
G :=
(3.24)
w C w
K = G ew
j cij wj
KX = X e
(3.23)
which we write as
w A z = 0
with
:= ln(K/G) .
z = arg min z z + w A z
z
X =
1 + e
Y =
and
1 + e
(3.28)
(3.18)
*
X
From
*
Y
/2
z z+ w Az
=0
z=z
(3.19)
0
-4
we have
z =
A w
2
-3
-2
-1
(3.20)
metry X () + Y () = 1 which is intuitively appealing. Also, when volatilities are equal, the log
= 2
.
(3.21) moneyness is equally distributed over both underw C w
lyings, which is again what one would intuitively expect from a sensible eective strike approximation
Upon resubstitution into (3.20), we arrive at
formula. In the limit of XY = 1, we obtain
A w
z =
.
(3.22)
X =
and
Y =
(3.29)
w C w
2
1+e
1 + e2
k = K , and the contribution of the continuous part
will be largely centered near k and tail o rapidly
*
X
as k due to the rapid decay of out-of-the
*
money options value B(X, k , (k )), assuming that
Y
/2
(k ) rises only moderately such as would be consis
tent with nite second and higher moments. Hence,
while the selection of an eective implied volatility
g(z) :=
wi Xi e j aij zj .
(3.36)
replication, we can value this option based on the
i
Taylor expansion with complete remainder for any
From
smooth function h(x) around k
z z + g(z) K
h (z)(x z) dz
=0
(3.37)
z=z
(3.31) we obtain
whence
zi +
ali wl Xl e
alj zj
= 0
(3.38)
Choosing h(X) = X 2 K and k := K , and taking eective geodesic strikes are then
the expectation over X, we obtain for the call option
Ki = Xi ei
(3.39)
2
E X K +
(3.33)
with
= A z .
(3.40)
k
+
h (z)(x z)+ dz .
(3.32)
X :=
wi Xi
:= ln(K/X) , (3.41)
and
we rewrite (3.35) as
wi Xi e
i
aij zj
= X e .
(3.42)
whence
1
2
z (2) =
(3.43)
(3.44)
1+2
A
C
(3.45) z =
A A
C C
1
3
2
C
( C )
A
C
(3.56)
Substituting (3.44) into (3.42) and expanding in
with 1 denoting the identity matrix. This nally
around 0 gives
gives us the second order expansion
(1)
i 1 +
i
1
2
(2)
aij zj + 2 zj
(1) 2
aij zj
+ 2
= 1 + + 1 2 + O 3
2
1
2
(3.57)
1+2
A A
C C
1
3
2
C
( C )
A
+ O 3 .
C
where we have used the normalized eective weights As an example, we show in gure 3 the rst and second order expansion solutions for a monthly observed
wi Xi
i := .
(3.46) Asian option of one year maturity in comparison with
X
a numerical solution for an arbitrarily chosen term
2 , equa- structure of arbitrage-free implied volatility.
Matching coecients up to order O
tion (3.45) gives
35%
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
T
i i
= 1
A z (1) = 1
30%
(3.47)
(3.48)
-0.5
25%
-1
20%
Az
(2)
1
2
1
2
(1)
A Az
(1)
(T )
, (3.49)
15%
-1.5
with the matrix dened to be diagonal and its elements being equal to those of . Expanding (3.38)
in yields
(1)
+ 2 zi
(1)
NL2SOL
5%
(3.50)
(2)
wl Xl ali 1 +
= O
10%
Lognormal expansion, second order
-2
-2.5
(2)
zi
(1)
alj zj
z (1) = (1) X A
0%
(3.51)
(3.58)
1
1
(1) =
X C
(3.53)
z =
C
X
and hence
z (1) =
A
.
C
i.e.,
(3.54)
zi =
K X
vX
aij wj Xj
(3.59)
wi Xi cij wj Xj .
(3.60)
with
1
1 3 C C
1
(2) =
2
2 2
X C
( C )
vX :=
(3.55)
i,j
Acknowledgement
The author is grateful to Charles-Henri Roubinet,
Head of Quantitative Research at VTB Capital, for
pointing out the results in [ABOBF02], and for authorizing the release of the ndings presented here
(originally from mid 2011, and rst completed with
the second order expansion in March 2012) into the
public domain.
References
[ABOBF02] M. Avellaneda, D. Boyer-Olson, J. Busca, and P. Friz.
Reconstructing volatility. Risk, pages 9195, October 2002.
www.math.nyu.edu/faculty/avellane/
Avellaneda.pdf.
[DGW81]
[Var67]
S. Varadhan. Diusion processes in a small time interval. Communications on Pure and Applied Mathematics, 20(4):659685, November 1967.