Mixing Models To Capture Stock Price Volatility Markov Lecture INFORMS Annual Meeting October 12-15, 2008 Washington, DC
Mixing Models To Capture Stock Price Volatility Markov Lecture INFORMS Annual Meeting October 12-15, 2008 Washington, DC
Mixing Models To Capture Stock Price Volatility Markov Lecture INFORMS Annual Meeting October 12-15, 2008 Washington, DC
Markov Lecture
INFORMS Annual Meeting
October 12–15, 2008
Washington, DC
Steven E. Shreve
Department of Mathematical Sciences
Carnegie Mellon University
Slides available at
www.math.cmu.edu/users/shreve
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Outline
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Black-Scholes-(Merton)
European call: Right to buy one unit of a risky asset at an
expiration time T at a strike price K agreed upon today (time
zero). The call pays (ST − K )+ , max{ST − K , 0} at expiration.
where
I S0 is today’s price of the risky asset,
I r is the continuously compounding rate of interest,
I N is the standard cumulative normal distribution function,
I
1 S0 1
d± = √ log − r ± σ2 T .
σ T K 2
I σ, which is positive, is the risky asset price “volatility.”
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What Black-Scholes-(Merton) teaches us
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Derivation of Black-Scholes-(Merton)
Replicate the call payoff by trading.
where
I W is a Brownian motion on (Ω, F, P) relative to a filtration
{Ft }0≤t≤T ,
I αt is an adapted process,
I σ is a positive constant.
Because αt is not required to be constant, nor even
deterministic, St is not assumed to be a geometric Brownian
motion.
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Portfolio
Create a portfolio of cash and the risky asset whose value at each
time t is the value of the call at that time.
I Xt – Value of the portfolio at time t.
I ∆t – Number of units of the risky asset held by the portfolio
at time t.
I Xt − ∆t St – Amount of cash held by the portfolio at time t.
I Evolution of portfolio value –
dXt = ∆t dSt , 0 ≤ t ≤ T.
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Matching evolutions
Let c(t, St ) denote the price of the call at time t when the
underlying asset price is S(t). Note: c(T , s) = (s − K )+ for all
s > 0.
Itô’s formula:
1
dc t, St = ct t, St dt + cs t, St dSt + css t, St dSt dSt
2 | {z }
σ 2 St2 dt
?
= dXt
= ∆t dSt .
Replication:
Start with X0 = c(0, S0 ) and take ∆t = cs (t, St ), 0 ≤ t ≤ T .
Then XT = c(T , ST ) = (ST − K )+ .
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Risk-neutral (martingale) probability measure1,2
We write
hα i
t
dSt = αt St dt + σSt dWt = σSt dt + dWt = σSt d W
ft ,
σ
where Z t
αu
W
ft = du + Wt .
0 σ
Using Girsanov’s Theorem, we construct a new probability measure
e under which W
P f is a Brownian motion. Under P,
e the risky asset
price is a geometric Brownian motion and a martingale. P
e is called
the risk-neutral measure.
1
Harrison, J. M. & Kreps, D. M. (1979) Martingales and arbitrage in
multiperiod security markets, J. Econom. Theory 20, 381–408
2
Harrison, J. M. & Pliska, S. R. (1981) Martingales and stochastic
integrals in the theory of continuous trading, Stoch. Proc. Appl. 11, 215–260.
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Risk-neutral pricing
dSt = σSt d W
ft .
For 0 ≤ t ≤ T and s > 0, define
e ST − K + St = s .
f (t, s) = E
Then
f (T , s) = (s − K )+ = c(T , s), s > 0.
The Kolmogorov backward equation for f (t, s) is
1
ft (t, s) + σ 2 s 2 fss (t, s) = 0.
2
In other words, f (t, s) = c(t, s).
0.50
0.25
Stock
price
22 23 24 25 26 27 28 29 30 31 32
Strike
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Why does this matter?
Pricing – We want a model that we can calibrate to options that
are traded and then use to price options that are not traded.
Hedging
I Hedge a book of options. Negative of replication.
I Want total portfolio (book plus hedge) to be insensitive to
price changes.
I Requires a single model for the underlying asset price.
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Four ways to proceed
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Mixture of Black-Scholes-(Merton) models
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Four ways to proceed
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Stochastic volatility models
Example (Heston3 )
√
dSt = αt St dt + vt St dWt1 ,
√
= λ v − vt dt + β vt dWt2 ,
dvt
hW , W 2 it
1
= ρt.
3
S. Heston (1993) A closed-form solution for options with stochastic
volatility, with applications to bond and currency options, Review Financial
Studies 6, 327–343.
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Stochastic volatility models (continued)
dSt = αt St dt + e Yt St dWt1 ,
λ β
= 2 Y − Yt dt + dWt2 ,
dYt
ε ε
hW 1 , W 2 it = ρt.
4
J.-P. Fouque, G. Papanicolaou and R. Sircar (2000) Derivatives in
Financial Markets with Stochastic Volatility, Cambridge University Press.
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Comments on stochastic volatility models
Calibration:
I First choose parameters, and then “run” the model to output
option prices.
I Compare model outputs with market prices. Try to choose
better parameters, typically to reduce the sum of squared
errors. This is a nonlinear optimization problem in which each
function evaluation is expensive.
I Subsequent recalibrations result in paper profits or losses and
upset hedges.
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Four ways to proceed
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Implied volatility models
Start with c 0, S0 ; t, K for 0 < t ≤ T and K > 0. For each t and
K , define the implied volatility σ(t, K ) to be the solution of the
equation
+
1 2
c 0, S0 ; t, K = E S0 exp σ W (t) − σ t −K .
e f
2
| {z }
St
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Arbitrage problem for implied volatility models
5
P. Schönbucher, A market model for stochastic implied volatility, Working
paper, May 1999.
6
M. Schweizer and J. Wissel (2008), Term structure of implied volatilities:
absence of arbitrage and existence results, Math. Finance 18, 77-114.
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Four ways to proceed
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Local volatility model – Implying risk-neutral densities from
call prices.
∂ 1 ∂2 2
p(0, S0 ; T , s) = γ (T , s)p(0, S0 ; T , s) .
∂T 2 ∂s 2
Again we set p(T , s) = p(0, S0 ; T , s). Then
Z ∞
∂ ∂
c 0, S(0); T , K = (s − K ) p(T , s) du
∂T K ∂T
1 ∞ ∂2
Z
= (s − K ) 2 γ 2 (T , s)p(T , s) ds.
2 K ∂s
7
B. Dupire (1994) Pricing with a smile, Risk 7, 18–20.
8
E. Derman and I. Kani (1994) Riding on a smile, Risk 7, 32–39
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Implying the local volatility surface.
Integrate by parts:
∞
∂2 2
Z
∂ 1
c 0, S(0); T , K = (s − K ) γ (T , s)p(T , s) ds
∂T 2K ∂s 2
1 ∞
Z
∂ 2
= − γ (T , s)p(T , s) ds
2 K ∂s
1 2
= γ (T , K )p(T , K ).
2
Recall
∂2
p(T , K ) = 2
c 0, S(0); T , K .
∂K
Solve for the function γ 2 (T , K ) for T in some range and K > 0.
Recall σ(T , K )K = γ(t, K ).
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Local volatility model – Practical issues
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Local volatility model – Theoretical issues
Theorem (First Fundamental Theorem of Asset Pricing9 )
Assume
I underlying asset is a semimartingale,
I call price processes are semimartingales,
I there is no free lunch with vanishing risk (essentially, no
arbitrage).
Then there exists a risk-neutral probability measure P
e under which
all these price processes are local martingales.
Under mild additional conditions, then S has the representation
dSt = γt · d W
ft ,
10
N. Krylov (1984) Once more about the connection between elliptic
operators and Itô’s stochastic equations, Statistics and Control of Stochastic
Processes, Steklov Seminar, 214–229.
11
I. Gyöngy (1986) Mimicking the one-dimensional marginal distributions of
processes having an Itô differential, Prob. Theory and Related Fields 71,
501–516.
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Local volatility model – Mixture example
e 0 = c1 } = P{σ
Assume P{σ e 0 = c2 }, where c2 > c1 > 0. Assume
σt = σ0 so γt = σ0 St , 0 ≤ t ≤ T,
where
dSt = σ0 St d W
ft , 0 ≤ t ≤ T.
”Smallest eigenvalue” of γt2 = σ0 St2 is not bounded away from
zero.
Nonetheless, there is a local volatility surface σ(t, s), and the
stochastic differential equation
I dSt = σ0 St d W
ft – choose a volatility at time zero and use it
throughout.
I dStvs = σ(t, Stvs )Stvs dWtvs – time-varying, state-dependent
volatility.
I If S0 = S0vs , then St and Stvs have the same one-dimensional
distributions for all t ≥ 0, so ...
I prices of calls on S agree with prices of calls on S vs .
I S vs makes sense as a dynamic model. S does not.
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Dynamic mixture model - Outline of a general construction
Choose a sequence of partitions
and define
Mt , max Su .
0≤u≤t
where
Mtvs , max Suvs ,
0≤u≤t
Comments:
γ 2 (t, s, m) = E
e γ 2 St = s, Mt = m
I t
I The stated theorem is a corollary of a more general result.
I At the level of generality given here, there can be multiple
weak solutions to
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Conclusions
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