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Stochastic Local Volatility Models: Theory and Implementation

Conference Paper · December 2010

DOI: 10.13140/2.1.1662.9120

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Stochastic Local Volatility Models:
Theory and Implementation

Artur Sepp

Bank of America Merrill Lynch

University of Leicester, UK
December 9, 2010

1
Plan of the presentation

1) Hedging and volatility

2) Review of volatility models

3) Local volatility models with jumps and stochastic volatility

4) Calibration using Kolmogorov equations

5) PDE based methods in one dimension

6) PDE based methods in two dimensions

7) Illustrations

2
References

Some theoretical and practical details for my presentation can be

found in:

1) Sepp, A. (2007) Affine Models in Mathematical Finance: an An-

alytical Approach, PhD thesis, University of Tartu
http://math.ut.ee/~spartak/papers/seppthesis.pdf

2) Sepp, A. (2012) An Approximate Distribution of Delta-Hedging

Errors in a Jump-Diffusion Model with Discrete Trading and Trans-
action Costs, Quantitative Finance, 12(7), 1119-1141
http://ssrn.com/abstract=1360472

3
Volatility modelling

What is important for a competitive pricing and hedging model?

1) Consistency with the observed market dynamics implies stable

model parameters and hedges

2) Consistency with vanilla option prices ensures that the model

fits the risk-neutral distribution implied by these prices and that the
model gamma is not much different from the market implied gamma

4
Hedging and volatility I

Let us consider a vanilla option and for simplicity assume zero interest
rates and dividends

We can find the option value U (σ)(t, S) by solving the celebrated

Black-Scholes-Merton (1973) partial differential equation (PDE) with
log-normal volatility parameter σ:
(σ) 1 (σ)
Ut + σ 2S 2USS = 0, (1)
2
where t is current time and S is the spot price

To delta-hedge a short-position in this option we consider the follow-

ing volatilities:
σi - implied volatility for computing option value U (σi)(t, S)
(σ )
σh - hedging volatility for computing option delta US h (t, S)

Note that σh might also include the vega adjustment, which is change
in σi given change in the spot, so in general σi 6= σh
5
Hedging and volatility II

The delta-hedged position at time tn:

Π(tn) = S(tn)∆(σh)(tn, S(tn)) − U (σi)(tn, S(tn))

One period profit-and-loss realized over time period δtn is:

δΠ(tn) = S(tn−1) + δS(tn) ∆(σh)(tn−1, S(tn−1))

− U (σi)(tn−1 + δtn, S(tn−1) + δS(tn)) − Π(tn−1)

where δS(tn) = S(tn) − S(tn−1) and δtn = tn − tn−1

6
Hedging and volatility III Consider Taylor series of U (σi)(tn−1 +
δtn, S(tn−1) + δS(tn)):

U (σi)(tn−1 + δtn, S(tn−1) + δS(tn)) ≈ U (σi)(tn−1, S(tn−1))

1
+ δtnΘ(σ i ) (tn−1, S(tn−1)) + δS(tn)∆ (tn−1, S(tn−1)) + (δS(tn))2 Γ(r)(tn−1
(r)
2
where Θ(σi)(tn−1, S(tn−1)) is the option theta, and ∆(r)(tn−1, S(tn−1))
and Γ(r)(tn−1, S(tn−1)) are realized delta and gamma:
∂ (σi)
Θ(σi)(tn−1, S(tn−1)) = U (t, S(tn−1)) |t=tn−1
∂t
(r) ∂ (σi)
∆ (tn−1, S(tn−1)) = U (tn−1, S) |S=S(tn)
∂S
U (σi)(tn−1, S(tn)) − U (σi)(tn−1, S(tn−1))
≈
S(tn) − S(tn−1)
(r) ∂
Γ (tn−1, S(tn−1)) = ∆(r)(tn−1, S) |S=S(tn)
∂S
∆(r)(tn−1, S(tn)) − ∆(r)(tn−1, S(tn−1))
≈
S(tn) − S(tn−1)
7
Hedging and volatility IV
One period realized profit-and-loss is approximated by:
h i
(σ ) (r)
δΠ(tn) = ∆ h (tn−1, S(tn−1)) − ∆ (tn−1, S(tn)) δS(tn)
1
− δtnΘ (σ i ) (tn−1, S(tn−1)) − (δS(tn))2 Γ(r)(tn−1, S(tn−1))
2
Note that option theta satisfies the BSM PDE:
1
Θ(σi)(t, S) = − σi2S 2Γ(σi)(t, S)
2
If the delta-hedging is rebalanced at discrete times tn, the realized
profit-and-loss, P&L, Π(T ) at the option maturity is
Xh i
Π(T ) = ∆(σh)(t n−1 , S(tn−1 )) − ∆
(r) (tn−1, S(tn−1)) δS(tn)
n
1 Xh i
+ σi Γ i (tn−1, S(tn−1)) − V (tn)Γ (tn−1, S(tn−1)) S 2(tn−1)δtn
2 (σ ) (r)
2 n
where V (tn) is the realized variance
!2
1 S(tn) − S(tn−1)
V (tn) =
δtn S(tn−1)
8
Hedging and volatility V. Modelling objective A:
Find a pricing and hedging model that
1) predicts the correct delta: ∆(σh)(tn−1, S(tn−1)) ≈ ∆(r)(tn−1, S(tn−1)),
then the P&L will be independent from the realized price path
(note that ∆(σh)(tn−1, S(tn−1)) is implied by the hedging model while
∆(r)(tn−1, S(tn−1)) represents actual change in option price observed
in the market given change in the spot and associated change in
implied volatility σi)

2) predicts the correct gamma: Γ(σi)(tn−1, S(tn−1)) ≈ Γ(r)(tn−1, S(tn−1))

(note that Γ(σi)(tn−1, S(tn−1)) is also implied by the hedging model
while Γ(r)(tn−1, S(tn−1)) is the realized change in delta given change
in spot and associated change in implied volatility σi)

If the model satisfies 1) and 2), realized P&L greatly simplifies to

1 X 2 
Π(T ) = σi − V (tn) Γ(σi)(tn−1, S(tn−1))S 2(tn−1)δtn
2 n
The ”edge” comes from the spread between the implied volatility
squared and the realized variance: σi2 − V (tn)
9
Volatility modelling VI. Modelling objective B
If the option can be sold at implied variance σi2 that is (much) higher
1 RT
than the realized variance T 0 V (t0)dt0 then Π(T ) is expected to be
positive because Γ(σi)(t, S(t)) is positive for vanilla options with con-
vex pay-offs (see Sepp (2011) for approximate distribution of Π(T ))

To ”materialize” the ”edge” as the P&L, it is important to have a

model that is consistent with 1) and 2)

For exotic options, considerations might be more complicated as

Γ(σi)(t, S(t)) and Γ(r)(t, S(t)) might change the sign and generally
higher order risks need to be hedged

Still, implications 1) and 2) are important for a competitive pricing

and hedging model. To conclude:
1) Consistency with the observed market dynamics implies stable
model parameters and hedge ratios
2) Consistency with vanilla option prices ensures that the model fits
the price distribution implied by these prices and that the model
gamma is not much different from the market implied gamma
10
Overview I. Black-Scholes-Merton

I will start with a brief review of volatility models

Black-Scholes-Merton (1973) considered log-normal model:

dS(t) = µ(t)S(t)dt + σS(t)dW (t), S(0) = S, (2)
where W (t) is the Brownian motion and µ(t) is the risk-neutral drift
(typically, µ(t) = r(t) − d(t), where r(t) and d(t) are deterministic
instantaneous interest and dividend rates)

The constant volatility σ is independent from both the spot price and
any extra factors

The model is not realistic in the presence of the skew observed in the
equity markets (out-of-the money puts are relatively expensive than
out-of-the money calls)

In practice, the BSM model is as a ”static” tool: price quotation,

implied volatility parametrization, benchmarking
11
Illustration for options on the S&P 500

60% 0.07

50% 0.06
Implied BSM volatility

BSM volatility, T=1month BSM density, T=1month

Probability density
Market density, T=1month
Market volatility, T=1month 0.05 BSM density, T=1year
40%
BSM volatility, T=1year Market density, T=1year
0.04
Market volatility, T=1year
30%
0.03
20%
0.02

10% 0.01

0% 0.00
0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 0.00 0.22 0.43 0.65 0.86 1.08 1.29 1.51 1.73
K, strike=K*Forward(T) S', spot=S'*Forward(T)

Left: Market implied and BSM volatility at ATM strike for T =1month
an T =1year
Right: Corresponding market and BSM implied probability density

Market implied distribution is more skewed to the left

12
Overview II. Bachelier model, A

Bachelier (1900) proposed a normal dynamics:

dS(t) = µ(t)S(0)dt + σnormalS(0)dW (t), S(0) = S, (3)

The implied local log-normal volatility σloc(S(t)) (approximately):

S(0)
σloc(S(t)) = σnormal
S(t)

The Bachelier model produces the leverage effect: for small price the
volatility increases and vice versa

The non-zero probability of negative prices: the default event in the

financial terms (modelled as the first time S(t) hits zero)

13
Overview II. Bachelier model, B

From the modelling point of view, the Bachelier model is more realistic
than that of Black-Scholes-Merton

However, the model is little accepted in practice: people prefer to

think in relative terms rather than in absolute

In Bachelier model, we cannot compare risks of stock A with the

volatility of 100, 000% and stock B with the volatility of 10% without
looking at their spot prices

Now: stock A is the FTSE100 index with S(0) = 5, 700 and stock B
is a penny share with S(0) = 0.1

The equivalent log-normal volatility of A is 17.54% and that of B is

100.00%

14
Overview III. Jump-diffusion models
Merton (1976) introduced log-normal dynamics with normal jumps:
 
J
dS(t) = µ(t)S(t−)dt + σS(t−)dW (t) + (e − 1)dN (t) − λνdt S(t−)
(4)
where N (t) is a Poisson process with intensity λ, J is jump amplitude
with PDF $(J) = n(η, δ), and ν is the compensator:
Z ∞
0 1 2
ν= eJ $(J 0)dJ 0 − 1 = eη+ 2 δ − 1
−∞
Given jump in N (t), jump in S(t) is: ∆S(t) = S(t−)(eJ − 1) ≈ S(t−)J

Since the possibility of large jumps makes out-of-the-money puts more

expensive, jump-diffusions introduce the implied volatility skew

However, for longer periods (more than one year) the implied distri-
bution resembles to the Gaussian (by the central limit theorem)

Jump models have been extended to general Levy processes (Lewis

(2001), Levendorskii-Boyarchenko (2002), Carr et al (2003), Cont-
Tankov (2004), ...)
15
Overview IV. Stochastic volatility models Hull-White (1988):
dS(t) = µ(t)S(t)dt + V (t)S(t)dW (1)(t)
dV (t) = κ(θ − V (t))dt + V (t)dW (2)(t)
where < dW (1)(t), dW (2)(t) >= ρdt
Scott (1987):
dS(t) = µ(t)S(t)dt + eV (t)S(t)dW (1)(t)
dV (t) = κ(θ − V (t))dt + dW (2)(t)
Stein-Stein (1991):
dS(t) = µ(t)S(t)dt + V (t)S(t)dW (1)(t)
dV (t) = κ(θ − V (t))dt + dW (2)(t)
Heston (1993):
q
dS(t) = µ(t)S(t)dt + V (t)S(t)dW (1)(t)
q
dV (t) = κ(θ − V (t))dt +  V (t)dW (2)(t)
Jumps can be included (Bates (1996), Duffie et al (2000), ...)
16
Overview V. Parametric local volatility
Cox (1975) proposes the constant elasticity of the variance (CEV)
model:
 
dS(t) = µ(t)S(S)dt + σcev S β−1 (t) S(t)dW (t) (5)
Rubinstein (1983) proposes the dis-placed diffusion model
!
S(0)
dS(t) = µ(t)S(t)dt + σdis β + γ S(t)dW (t) (6)
S(t)
Both the CEV with β < 1 (typically, β ∈ [−5, −3] for single stocks
and indexes) and dis-placed diffusions exhibit the leverage effect and
the default possibility (from my experience, the dis-placed diffusion
model is easier to deal with)

Ingersoll (1996), Zuhlsdorff (1999) and Lipton (2000) consider the

hyperbolic volatility:
!
S(t) S(0)
dS(t) = µ(t)S(S)dt + σhyp α +β+γ S(t)dW (t) (7)
S(0) S(t)

17
Overview VI. Non-parametric local volatility
In general, parameters of parametric local volatility models need to
be calibrated to observed market prices in least squares sense

Derman-Kani (1994), Rubinstein (1994), Dupire (1994) consider the

one-dimensional diffusion model
dS(t) = µ(t)S(t)dt + σ(loc)(t, S(t))S(t)dW (t), (8)
with local volatility σ(loc)(t, S(t)) implied from observed market prices
of vanilla options

Andersen-Andreasen (2000) and Carr et al (2004) introduce the local

volatility with jumps

JP Morgan (1999) and Blacher (2001) consider the local volatility

model with stochastic variance driven by the Heston model

Lipton (2002) introduces the local stochastic volatility with jumps

Let me summarise the two main categories of the models used in

practice for exotic options
18
Overview VII. Volatility models
1) Non-parametric local volatility models (Dupire (1994), Derman-
Kani (1994), Rubinstein (1994))
”+” are consistent with today’s market prices by construction
”-” but they tend to be poor in replicating the market dynamics of
spot and volatility (implied volatility tends to move too much given
a change in the spot, no mean-reversion effect)
”-” especially, it is impossible to tune-up the volatility of the implied
volatility as there is simply no parameter for that!

2) Parametric stochastic volatility models (Heston (1993))

”+” tend to be more in line with the market dynamics
”+” equipped to model the term-structure (by mean-reversion pa-
rameters) and the volatility of the variance (by vol-of-vol parameters)
”-” need a least-squares calibration to today’s option prices
”-” unfortunately, any change in any of the parameters of the mean-
reversion or the vol-of-vol requires re-calibration of other parameters

3) Stochastic local volatility models (JP Morgan (1999), Blacher

(2001), Lipton (2002))
aim to include ”+”’s and cross ”-”’s of the first two models
19
Overview VIII. Model specification

1) Global factors

Select factors relevant for product risk: stochastic volatility, stochas-

tic interest rate, jumps, default risk, etc

(Guess) Estimate or calibrate model parameters for the dynamics of

these factors using either historical or market data

Parameters are updated infrequently

2) Local factors

Specify local factors such as local volatility or local drift (for quantos)

Parameters of local factors are updated frequently (on the run)

20
Stochastic local volatility models

Stochastic local volatility models allow:

1) Specify the dynamics for the instantaneous volatility

2) Fit the risk-neutral distributions implied by market prices of vanilla

options by specifying local volatility as function of the spot price

However, the model calibration requires robust numerical methods for

solving two-dimensional PDE-s

In general, a successful implementation of the model involves a decent

amount of both theoretical and practical exercises

21
Calibration of parametric models I. Forward-backward equations
I apply the methods for stochastic processes and partial differential
equations dating back to Kolmogorov foundational work (1931)

Consider a 1-d problem with stochastic factor S(t) for a product that
depends only on terminal value of S(T )
PV function U (t, S; T, K), 0 ≤ t ≤ T , solves the backward equation
as function of (t, S):
Ut(t, S) + LU (t, S) = −c(t, S), U (T, S) = u(S) (9)
u(S) and c(t, S) are pay-off and coupon functions, respectively
L is the infinitesimal operator corresponding to the dynamics of
S(t) (includes volatility, drift, discounting, jumps)

Transition probability density function, G(0, S0; t, S 0), aka Green’s

function in mathematical physics, solves the forward equation as
function of (t, S 0):
Gt(t, S 0) − L†G(t, S 0) = 0, G(0, S 0) = δ(S 0 − S0) (10)
where δ() is Dirac delta function and L† is operator adjoint to L
22
Calibration of parametric models II. Valuation formula
Multiply backward equation by G(0, S0; t, S) and integrate over (t, S):
Z TZ ∞
− G(0, S0; t0, S 0)c(t0, S 0)dS 0dt0
0 −∞
Z TZ ∞ h
G(0, S0; t , S )Ut(t , S ) + G(0, S0; t , S )LU (t , S ) dS 0dt0
0 0 0 0 0 0 0 0
i
≡
Z0∞ −∞
G(0, S0; T, S 0)U (T, S 0) − G(0, S0; 0, S 0)U (0, S 0)
h
=
−∞ #
Z T Z ∞ Z T
− Gt(0, S0; t0, S 0)U (t0, S 0)dt0 dS 0 + G(0, S0; t0, S 0)LU (t0, S 0)dt0dS 0
0 −∞ 0
Z ∞
= G(0, S0; T, S 0)u(S 0)dS 0 − U (0, S0)
−∞
Z T Z ∞ hn
L G(0, S0; t , S ) U (t , S ) − G(0, S0; t , S ) LU (t , S ) dS 0dt0
† 0 0 0 0 0 0 0 0
o n oi
−
0 −∞
where, in second line, the first term is integrated by parts, and, in
the last line, terminal condition for U (T, S) and initial condition for
G(0, S0; 0, S) are applied

23
Calibration of parametric models III. Consistency
Consistency condition for adjoint operators L and L† (can be checked
by integration by parts):
Z T Z ∞ hn
L G(0, S0; t , S ) U (t , S ) − G(0, S0; t , S ) LU (t , S ) dS 0dt0 = 0
† 0 0 0 0 0 0 0 0
o n oi

0 −∞
(11)
Then the PV can be computed by convolution:
Z ∞
U (0, S0; T, K) = G(0, S0; T, S 0)u(S 0)dS 0
−∞
Z TZ ∞ (12)
+ G(0, S0; t0, S 0)c(t0, S 0)dS 0dt0
0 −∞
This formula is known as Duhamel’s principle (19th century) in
mathematical physics or Feynman-Kac formula (1949) in probability

24
Calibration of parametric models IV. Implications

Typically, for a parametric model, model parameters are assumed to

be piece-wise constant in time with jumps at times {Tn}, where {Tn}
is set of maturity times of listed options

Implications for calibration by bootstrap:

1) Given calibrated set of piece-wise constant model parameters at

time Tm−1 and known values of G(Tm−1, S), make a guess for param-
eters at time Tm and compute G(Tm, S)

2) Apply Duhamel’s formula (12) to compute PV-s of specified vanilla

instruments

3) By changing parameters for time Tm, minimize the sum of squared

differences between model and market prices

4)After convergence, store G(Tm, S) and go to the next time slice

25
Calibration of parametric models V. Numerical schemes
Consistency condition (11) for adjoint operators L and L† is based on
theoretical arguments:
Z T Z ∞ hn
L G(0, S0; t , S ) U (t , S ) − G(0, S0; t , S ) LU (t , S ) dS 0dt0 = 0
† 0 0 0 0 0 0 0 0
o n oi

0 −∞
It is not necessarily true for discrete numerical schemes! (see Lipton
(2007) for a consistent scheme)

Implications for numerical schemes:

1) For adjoint operators, if M is spacial discretisation of L then M T
should be spacial discretisation of L†

2) Both forward and backward equations should be solved using the

same schemes

3) It is enough to develop either forward or backward scheme

4) L and L† have the same values of the operator norm, so the con-
vergence of the forward scheme implies convergence of the backward
scheme and vice versa
26
Local volatility calibration I. Basic facts

Let G(t, S; T, S 0) be the risk-neutral probability density at time T and

state S 0 given that S(t) = S:
G(t, S; T, S ) = P S(T ) ∈ dS | S(t) = S dS 0
0 0
h i
(13)

Assume that the discount rate is deterministic

By applying the risk-neutral valuation and Duhamel’s formula (12),

un-discounted call value C(T, K) solves:
Z ∞
C(T, K) = (S 0 − K)+G(t, S; T, S 0)dS 0
Z0∞ (14)
= (S 0 − K)G(t, S; T, S 0)dS 0
K

By basic calculus:
Z ∞
CK (T, K) = − G(t, S; T, S 0)dS 0
K (15)
CKK (T, K) = G(t, S; T, K)
27
Local volatility calibration II. Breeden-Litzenberger formula

Consider a one-dimensional diffusion:

dS(t) = µ(t)S(t)dt + σ(loc,dif)(t, S(t))S(t)dW (t), S(0) = S (16)
where σ(loc,dif) is the local volatility of the diffusion

Note that if call prices are given for all strikes and maturities,
{C (market)(K, T )}, then by (15) the risk-neutral distribution satisfies
(Breeden-Litzenberger (1978)):
(market)
G(market)(T, K) = CKK (T, K)

Calibration objective: how we should specify σ(loc,dif)(T, S 0) so that

the implied risk-neutral distribution G(t, S; T, S 0) is consistent with
G(market)(T, K)

28
Local volatility calibration III. Kolmogorov equation

The risk-neutral probability density G(t, S; T, S 0) solves the forward

Kolmogorov equation:
1 0 0 2
 
0

GT − (σ(loc,dif)(T, S )S ) G 0 0 + µ(T )S G 0 = 0
2 SS S
G(t, S; t, S 0) = δ(S 0 − S)

Multiply by (S 0 − K)+ and integrate over S 0

Initial condition:
Z ∞
(S 0 − K)+δ(S 0 − S)dS 0 = (S − K)+
0
Time derivative:
Z ∞
(S 0 − K)+GT dS 0 = CT (T, K)
0

29
Diffusion term:
Z ∞
0 (σ(loc,dif)(T, S )S ) G 0 0 dS 0 = σ(loc,dif)
0 0
 
(S − K) + 2 2 (T, K)K 2G(t, S; T, K)
0 SS
2
= σ(loc,dif) (T, K)K 2CKK (T, K)
Drift term:
Z ∞
0 µ(T )S G 0 dS 0 = µ(T )KCK (T, K) − µ(T )C(T, K)
0
 
(S − K) +
0 S

As a result, we obtain the forward equation for call option prices as

function of the ”forward” arguments T and K:
1 2
CT − σ(loc,dif) (T, K)K 2CKK + µ(T )KCK − µ(T )C = 0
2
C(t, K) = (S(t) − K)+
2
Inverting the PDE in terms of the σ(loc,dif) , we obtain Dupire equa-
tion (1994) for local volatility:
2 CT (T, K) + µ(T )KCK (T, K) − µ(T )C(T, K)
σ(loc,dif) (T, K) = 1 K 2C
(17)
2 KK (T, K)
30
Jump-diffusion model I

Andersen-Andreasen (2000) consider a Merton jump-diffusion extended

to local volatility:
dS(t) =µ(t)S(t−)dt + σ(loc,jd)(t, S(t−))S(t−)dW (t)

J
 (18)
+ (e − 1)dN (t) − λνdt S(t−), S(0) = S
where σ(loc,jd) is the local volatility corresponding to the jump-diffusion

31
Jump-diffusion model II Kolmogorov equation
Now G(t, S; T, S 0) solves the forward Kolmogorov equation:
1
(σ(loc,jd)(T, S )S ) G 0 0 + µ(T )S G 0 − λI(S 0) = 0
0 0 0
  
GT − 2
2 SS S
G(t, S; t, S 0) = δ(S 0 − S)
Z ∞
0 0
I(S 0) = G(S 0e−J )e−J $(J 0)dJ 0 + (νS 0G)S 0 − G
−∞
Proof: for the backward equation the jump term is given by:
Z ∞
0
I ?(S 0) = U (S e )$(J 0)dJ 0 − νS 0US 0 − U
0 J
−∞
Multiply by G(t, S; T, S 0) and integrate over S 0:
Z ∞ Z ∞
0
G(t, S; T, S 0)I ?(S 0)dS 0 = G(t, S; T, S 0)U (S 0eJ )$(J 0)dJ 0dS 0
−∞
Z ∞ Z ∞ −∞
− νG(S 0)S 0US 0 dS 0 − GU dS 0
Z−∞
∞ Z ∞
−∞ 
0 0
= G(t, S; T, S 0e−J )e−J $(J 0)dJ 0 + (νS 0G)S 0 − G U (S 0)dS 0
−∞ −∞
0
by making substitution S 0eJ → S 0 and integrating by parts
32
Jump-diffusion model IV
Following the same steps consider:
Z ∞
I †(K) = (S 0 − K)+I(S 0)dS 0
Z ∞ 0 Z ∞
0 0
= (S 0 − K)+ G(S 0e−J )e−J $(J 0)dJ 0dS 0 + νKCK − (ν + 1)C
Z0∞ −∞
−J 0 J0
= C(Ke )e $(J 0)dJ 0 + νKCK − (ν + 1)C
−∞
As a result, obtain the forward equation for call option prices:
1 2
CT − σ(loc,jd)(T, K)K 2CKK + µ(T )KCK − µ(T )C − λI †(K) = 0
2
C(t, K) = (S(t) − K)+
2
Inverting σ(loc,jd) yields Andersen-Andreasen equation (2000):

2 CT (T, K) + µ(T )KCK (T, K) − µ(T )C(T, K) − λI †(K)

σ(loc,jd)(T, K) = 1 K 2C
2 KK (T, K)
2 λI †(K)
= σ(loc)(T, K) − 1
2
2 K CKK (T, K)
33
Stochastic local volatility I
Consider 2-d stochastic local volatility diffusion:

dS(t) = µ(t)S(t)dt + σ(loc,sv)(t, S(t))ϑ(t, Y (t))S(t)dW (1)(t), S(0) = S,

dY (t) = θ(Y (t))dt + (Y (t))dW (2)(t), Y (0) = Y
(19)
where σ(loc,sv) is the local volatility of the diffusion with stochastic
volatility and < dW (1)(t), dW (2)(t) >= ρdt

ϑ(t, Y (t)) is the mapping function of Y (t) into the spot dynamics

34
Stochastic local volatility II. Calibration
Conventional approach (for example, Ren-Madan-Qian (2007)) is to
use Gyöngy (1986) mimicking theorem yielding:
h i
2 2 2
σ(loc,sv)(T, K)E ϑ (T, Y (T )) | S(T ) = K = σ(loc,dif) (T, K)

Gyöngy theorem is purely probabilistic analysis, we follow original

Lipton’s (2002) PDE-based approach applied directly in the context
of stochastic local volatility calibration

The risk-neutral probability density G(t, S, Y ; T, S 0, Y 0) solves the for-

ward Kolmogorov equation:
1 0 0 0 2
 
0

GT − (σ(loc,sv)(T, S )ϑ(T, Y )S ) G 0 0 + µ(T )S G 0
2 SS S
1 2 0
 (Y )G 0 0 + θ(Y 0)G 0
   
−
2 Y Y Y
0 0 0 0
 
− ρσ(loc,sv)(T, S )ϑ(T, Y )(Y )S G 0 0 = 0
SY
G(t, S, Y ; t, S 0, Y 0) = δ(S 0 − S)δ(Y 0 − Y )

35
Stochastic local volatility III. Calibration

Consider the unconditional density:

Z ∞
U (t, S; t, S 0) = G(t, S, Y ; T, S 0, Y 0)dY 0
−∞
The diffusion term becomes:
Z ∞ 
(T, S 0)ϑ(T, Y 0)S 0)2G 0

(σ(loc,sv) dY
−∞ S 0S 0
Z ∞  
= ϑ2(T, Y 0)GdY 0 (σ(loc,sv)(T, S 0)S 0)2
−∞ S 0S 0
= V (T, S 0)(σ(loc,sv)(T, S 0)S 0)2U (T, S 0)
 
S 0S 0
where V (T, S 0) is the conditional variance:
R∞ 2 (T, Y 0 )G(t, S, Y ; T, S 0 , Y 0 )dY 0
ϑ
V (T, S 0) = −∞
U (t, S; T, S 0)
R∞ 2 0 0 0 0
−∞ ϑ (T, Y )G(t, S, Y ; T, S , Y )dY
= R∞
0 0 0
−∞ G(t, S, Y ; T, S , Y )dY

36
Stochastic local volatility IV. Calibration

Remaining terms are trivial, yielding:

1 0 0 0 2
 
0

UT − V (T, S )(σ(loc,sv)(T, S )S ) U 0 0 + µ(T )S U 0 = 0
2 SS S
U (t, S; t, S 0) = δ(S 0 − S)

PDE for call prices:

1
CT − (V (T, K)(σ(loc,sv)(T, K)K)2CKK + µ(T )KCK − µ(T )C = 0
2

The model is consistent with the Dupire local volatility if

2
V (T, K)σ(loc,sv) 2
(T, K) = σ(loc,dif) (T, K)

As a result, the stochastic local volatility is specified by:

2
σ(loc,dif) (T, K)
2
σ(loc,sv) (T, K) =
V (T, K)
37
Stochastic local volatility with jumps I

Consider a two-dimensional stochastic local volatility jump-diffusion:

dS(t) =µ(t)S(t−)dt + σ(loc,svj)(t−, S(t−))ϑ(t−, Y (t−))S(t−)dW (1)(t)

 
J
+ (e − 1)dN (t) − λνdt S(t−), S(0) = S,
dY (t) =θ(Y (t))dt + (Y (t))dW (2)(t) + ΥdN (t), Y (0) = Y
(20)
where σ(loc, svj) is the local volatility of the diffusion with stochastic
volatility and jumps

Υ is the amplitude of the jump in Y (t) with PDF ς(Υ)

Jumps are simultaneous in S(t) and Y (t)

38
Stochastic local volatility with jumps II

The risk-neutral probability density G(t, S, Y ; T, S 0, Y 0) solves the for-

ward Kolmogorov equation:
1 0 0 0 2
 
0

GT − (σ(loc,svj)(T, S )ϑ(T, Y )S ) G 0 0 + µ(T )S G 0
2 SS S
1 2 0
 (Y )G 0 0 + θ(Y 0)G 0
   
−
2 Y Y Y
− ρσ(loc,svj)(T, S )ϑ(T, Y )(Y )S G 0 0 − λI(S 0) = 0
0 0 0 0
 

Z ∞ Z ∞ SY
I(S 0) = G(S 0e−J , Y 0 − Υ)e−J $(J)ς(Υ)dJdΥ + (νS 0G)S 0 − G
−∞ −∞
G(t, S, Y ; t, S , Y 0) = δ(S 0 − S)δ(Y 0 − Y )
0

39
Stochastic local volatility with jumps III

PDE for call prices:

1
CT − (V (T, K)(σ(loc,svj)(T, K)K)2CKK + µ(T )KCK − µ(T )C − λI †(K) = 0
2
where V (T, K) is the unconditional variance

2
Inverting σ(loc,svj) (T, K), yields Lipton equation (2002):

2 CT (T, K) + µ(T )KCK (T, K) − µ(T )C(T, K) − λI †(K)

σ(loc,svj)(T, K) = 1 V (T, K)K 2 C
2 KK (T, K)
 
1 †
λI (K)
= σ 2 (T, K) − 
V (T, K) (loc,dif) 1 2
2 K CKK (T, K)
2
σ(loc,jd) (T, K)
=
V (T, K)

40
PDE based methods

Non-parametric local stochastic volatility can only be implemented

using numerical methods for partial integro-differential equations

These methods should be flexible to handle jumps in one and two

dimensions and the correlation term for two dimensions

I will review some of the available methods

For the backward problem, L is the infinitesimal operator correspond-

ing to model dynamics:
L = D + λJ

41
1-d Problem
Here D is the diffusion-convection operator:
1 2
DU (t, S) ≡ σ (t, S)S 2USS + µ(t)SUS + λU
2
J is the integral operator:
Z ∞
0
J U (t, S) ≡ U (t, Se )$(J 0)dJ 0
J
−∞
For the forward problem, we consider the operator L† adjoint to L:
L† = D† + λJ †
For both problems we denote the discretized diffusion and integral
operators by Dn and J, respectively

The diffusion operator is space and time dependent (denoted by n)

Care must be taken for discretization of the operator for the mean-
reverting process!

42
1-d Problem for diffusion problem I
N - number of points in the space grid
Dn - discrete diffusion matrix at time tn with dimension N × N
U n - the solution vector at time tn with dimension N × 1
I - the unit matrix with dimension N × N

Time-stepping methods of the choice:

Explicit method:
 
U n+1 = I+Dn+1 Un

Implicit method:
 
I−Dn+1 U n+1 = U n

θ method:
   
I − θDn+1 U n+1 = I + θDn+1 Un

with θ = 1
2 corresponding to Crank-Nicolson scheme
43
1-d Problem for diffusion problem II

The explicit method requires very fined grids and is highly unstable -
it should be avoided

The Crank-Nicolson scheme is unconditionally stable and is of or-

der (δS)2 and (δt)2, but might lead to negative probabilities for the
forward equation

The implicit method is unconditionally stable and does not lead to

negative densities, but it is of order (δt) and becomes less accurate
for longer maturities

My favourite is the predictor-corrector scheme:

 
I−Dn+1 e = Un
U

n+1

n+1 n 1 n+1 n
I−D U =U + D (U − U
e)
2
which is of order (δS)2 and (δt)2, and does not lead to negative
probabilities
44
Numerics for jump-diffusions I
Let me consider the forward equation with additive jumps (multiplica-
tive jumps can be handled in the log-space):
Z ∞
J G(x) = G(x − j)$(J 0)dJ 0
−∞

Let me consider discrete negative jumps with size −η, η > 0:

J G(x) = G(x + η)

Discretization is a simple linear interpolation:

J Gi = wGk + (1 − w)Gk+1
xk+1 −(xi +ν)
where k = min{k : xk+1 ≥ xi + ν} and w = xk+1 −xk

45
Numerics for jump-diffusions II
In the matrix form, for uniform spacial grid:
 
0 0 ... w 1 − w 0 ... 0 0

 0 0 ... 0 w 1 − w ... 0 0 

...
 
 
 
J =
 0 0 ... 0 0 0 ... w 1 − w 


 0 0 ... 0 0 0 ... 0 1  
...
 
 
0 0 ... 0 0 0 ... 0 0
J(p,N ) = 1, where p = min{p : xp + ν ≥ xN }

In general, for two-sided jumps, J is a full matrix:

The implicit method for the integral term leads to O(N 3) complexity
and is not practical
The explicit method leads to O(N 2) complexity but needs extra
care for stability

For exponential jumps, Lipton (2003) develops recursive scheme with

O(N ) complexity
46
Numerics for jump-diffusions III

In case of discrete jumps, we have two-banded matrix with p rows

that have non-zero elements

Consider solving a linear system:

(I − β J)X = R
where β = λδt, 0 < β < 1

We can solve this system by back-substitution with cost of O(N )

operations

47
Numerics for jump-diffusions IV
Consider θ and θJ schemes for the diffusion and the jump parts:
   
I − θDn+1 − θJ λn+1J U n+1 = I + θDn+1 + θJ λn+1J U n
where λn+1 = (tn+1 − tn)λ(tn+1)
The accuracy with θ = θJ = 2 1 is supposed to be O(dx2 ) + O(dt2 )

However, the matrix in the lhs will be full: the cost to invert is O(N 3)

Implicit-explicit method:
   
I−Dn+1 U n+1 = I + λn+1J U n

with accuracy of O(dx2) + O(dt)

θ-explicit method:
   
I − θDn+1 U n+1 = I + θDn+1 + λn+1J U n

with accuracy of O(dx2) + O(dt)

48
Numerics for jump-diffusions V. Andersen-Andreasen (2000)
scheme

Make the first half step with θ = 1 and θJ = 0 and the second half
step with θ = 1 and θJ = 1:
1 1
   
I − Dn+1 Ue = I + λn+1J U n
2 2
1 1
  
I − λn+1J U n+1 = I + Dn+1 Ue
2 2
with accuracy of O(dx2) + O(dt2)

When J is full, the second equation can be solved by the application

of the discrete Fourier transform (DFT) with the cost of O(N log N )

For discrete jumps, the second equation solved with cost of O(N )
operations

49
Numerics for jump-diffusions VI. d’Halluin et al (2005) scheme

Consider fixed point iterations:

Set V 1 = U n

Iterate for p = 1, .., p (p = 2 is good enough):

   
I − θDn+1 V p+1 = I + θDn+1 U n + λn+1JV p,

Set U n+1 = V p

The accuracy is O(dx2) + O(dt)

50
Numerics for jump-diffusions VII

My favourite is the implicit scheme with predictor-corrector applied

twice:
 
U
e (0) = I+D n+1 + λn+1J U n
 
I−D n+1 U
e =Ue (0)

n+1

n+1 (0) 1 n+1 e − U n)
I−D U =U
e + (D + λn+1J)(U
2

The accuracy is O(dx2) + O(dt2)

51
Numerical Methods for Two Dimensional Problem I

We consider the forward problem for U (t, x1, x2):

UT − MU = 0
(21)
U (0, x1, x2) = δ(x1 − x1(0))δ(x2 − x2(0))
where
M = D1 + D2 + C + λJ
D1 and D2 are 1-d diffusion-convection operators in x1 and x2 direc-
tions, respectively
C is the correlation operator
J is the integral operator for joint jumps in x1 and x2

Let D1 and D2 denote the discretized 1-d diffusion-convection oper-

ators in x1 and x2 directions, respectively

C and J are the discretized correlation and integral operator, respec-

tively
52
Douglas-Rachford (1956) scheme

Make a predictor and apply two orthogonal corrector steps:

e (0) = (I + C + λJ + D + D )U n
U 1 2
(I − θD1)U e (0) − θ D U n
e =U
1
(I − θD2)U n+1 = U
e − θD U n
2

In the second line, for each fixed index j we apply the diffusion oper-
ator in x1 direction; and solve the tridiagonal system of equations to
get the auxiliary solution U
e (·, x (j))
2

In the third line, keeping i fixed, we apply the diffusion step in x2

direction and solve the system of tridiagonal equations to get the
solution U n+1(x1(i), ·) at time tn+1

Complexity is O(N1N2) per time step

53
Craig-Sneyd (1988) scheme

Start as with Douglas-Rachford scheme make a second predictor and

again apply two orthogonal corrector steps:
e (0) = (I + C + λJ + D + D )U n
U 1 2
e (1) = U
(I − θD1)U e (0) − θ D U n
1
(I − θD2)U e (2) = U
e (1) − θ D U n
2
(3) (0) 1 e (2) − U n)
U
e =Ue + (C + λJ)(U
2
(I − θD1)U e (4) = U
e (3) − θ D U n
1
(I − θD2)U n+1 = U
e (4) − θ D U n
2

54
Hundsdorfer-Verwer (2003) scheme (in’t Hout-Foulon (2008))

Similar to Craig-Sneyd scheme with predictor including D1 and D2

e (2):
and the second corrector applied on U
e (0) = (I + C + λJ + D + D )U n
U 1 2
e (1) = U
(I − θD1)U e (0) − θ D U n
1
(I − θD2)U e (2) = U
e (1) − θ D U n
2
(3) (0) 1 
(2) n

U
e =Ue + (C + λJ + D1 + D2) U e −U
2
(I − θD1)U e (4) = U
e (3) − θ D Ue (2)
1
(I − θD2)U n+1 = U
e (4) − θ D U
2
e (2)

55
Discretisation of integral term

Direct methods are infeasible because of O(N12N22) complexity

DFT method (Clift-Forsyth (2008)) has O(N1N2 log N1N2) complex-

ity but suffers from problems associated with the DFT

Explicit methods with O(N1N2) complexity are available for discrete

and exponential jumps (Lipton-Sepp (2011))

The simplest case is if jumps are discrete with sizes η1 and η2:
J G = G(x1 − η1, x2 − η2)

This term is approximated by bi-linear interpolation with the second

order accuracy leading to the O(N1N2) complexity

56
Illustration I. Model specification
We specify a particular version of the LSV dynamics (20):
dS(t) = µ(t)S(t−)dt + σ(loc,svj)(t−, S(t−))ϑ(t−, Y (t−))S(t−)dW (1)(t)
−ν
 
+ (e − 1)dN (t) + λνdt S(t−), S(0) = S
dY (t) = −κY (t)dt + dW (2)(t) + ηdN (t), Y (0) = 0
(22)
where dW (1)(t)dW (2)(t) = ρdt
Convenient choice of ϑ(t, Y (t)):
ϑ(t, Y (t)) = eY (t)−V[Y (t)]
where V[Y (t)] is the variance of Y (t). Then if ρ = 0:
h i
2
E ϑ (t, Y (t)) | Y (0) = 0 = 1
Mapping ϑ(t, Y (t)) introduces the ”volatility-of-volatility” effect with-
out affecting the local volatility close to the spot
Simultaneous jumps in S(t) and Y (t) are discrete with magnitudes
−ν < 0 and η > 0 (note that jump variance will decrease the model
implied correlation between spot and volatility)
57
Illustration II. Model calibration

1) Specify time and space grids

2) Compute the local volatility using Dupire equation (17) on the

specified grid (interpolating implied volatilities in strikes and maturi-
ties)

3) Calibrate local stochastic volatility on the specified grid

4) Use backward PDE methods or Monte-Carlo simulations of the

local stochastic volatility model to compute values of exotic options

58
Illustration III. Local volatility calibration A
At initial time t0 = 0
i) initialize G0(x1(i), x2(j)) = 1x1(i)=x1(t0)1x2(j)=x2(t0)

ii) Set the conditional variance V (t1, x1(i)) = 1 so that

2
σ(loc,sv) 2
(t1, x1(i)) = σ(loc,dif) (t1, x1(i))

iii) Compute G1(x1(i), x2(j)) by solving the forward PDE

iv) Compute V (t1, x1(i)) by

P P 2 1
i j ϑ (t1 , x2 (j))G (x1 (i), x2 (j))
V (t1, x1(i)) = P 1
j G (x1 (i), x2 (j))
and set
2
σ(loc,dif) (t1, x1(i))
2
σ(loc,sv) (t1, x1(i)) =
V (t1, x1(i))
G) Repeat C) and D) and go to the next time step
59
Illustration III. Local volatility calibration B
At time tn given Gn−1(x1(i), x2(j)) and V (tn−1, x1(i))
i) Compute the local variance by:
2
σ(loc,dif) (tn, x1(i))
2
σ(loc,sv) (tn, x1(i)) =
V (tn−1, x1(i))

ii) Compute Gn(x1(i), x2(j)) by solving the forward PDE

iii) Compute V (tn, x1(i)) by

P P 2 n
i j ϑ (tn , x2 (j))G (x1 (i), x2 (j))
V (tn, x1(i)) = P n
j G (x1 (i), x2 (j))
and set
2
σ(loc,dif) (tn, x1(i))
2
σ(loc,sv) (tn, x1(i)) =
V (tn, x1(i))
D) Repeat B) and C) and go to the next time step
2
For stochastic volatility with jumps we use σ(loc,jd)
60
Illustration III. Local volatility calibration C

When we use predictor-corrector schemes:

i) Compute the predictor step using local stochastic volatility from

previous time step

ii) Update local stochastic volatility and compute the corrector step
with new volatility

iii) After the corrector step, compute new local stochastic volatility
and go to the next step

61
Illustration IV. Discrete dividends

At ex-dividend time tn:

S(tn+) = S(tn−) − Dn
where Dn is the cash dividend at time tn

Note that this corresponds to the negative jump in S(t) with a con-
stant magnitude Dn at deterministic time tn

Therefore the developed method for discrete negative jumps are read-
ily applied for discrete dividends

2
It is important that σ(loc,dif) is consistent with the discrete dividends

62
Illustration V. Local volatilities for options on the S&P 500

70% 80%
Dupire Local Volatility, T=1year
Dupire Local Volatility, T=1month
60% 70% SV Local Volatility, T=1year
SV Local Volatility, T=1month
50% 60%
Local Volatility

Local Volatility
50%
40%
40%
30%
30%
20%
20%
10% 10%
0% 0%
0.2 0.2 0.3 0.3 0.4 0.5 0.6 0.8 1.0 1.2 0.2 0.2 0.3 0.3 0.4 0.5 0.6 0.8 1.0 1.2
S', spot = S'*forward(T) S', spot = S'*forward(T)

Left: Dupire local volatility and LSV local volatilities at T=1 month
Right: ... at T=1 year

LSV local volatility is an adjustment to the skew implied by the

stochastic volatility part and is mostly flat
63
Illustration VI. Forward volatilities for options on the S&P 500

55% 60% 6m Spot skew, Local vol

6m Spot skew, Local vol
50% 55% 6m Spot skew, LSV

Implied BSM volatility

6m Spot skew, LSV
Implied BSM volatility

6m-6m Skew if S(6m)<0.9S(0), Local vol

45% 50%
6m-6m Skew if S(6m)>1.1S(0), Local vol 6m-6m Skew if S(6m)<0.9S(0), LSV
45%
40% 6m-6m Skew if S(6m)>1.1S(0), LSV
40%
35%
35%
30%
30%
25%
25%
20% 20%
15% 15%
10% 10%
0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5
K, Strike=K*Forward(T) K, Strike=K*Forward(T)

6m-6m skew: the implied volatility for a vanilla call option starting
in 6 month and maturing in one year from now with strike fixed in 6
months: K = S(T = 6m)
Left: 6m-6m skew if S(T = 6m) > 1.1S(0): the implied volatility for
the forward-start option conditional that S(T = 6m) > 1.1S(0)
Right: 6m-6m skew if S(T = 6m) < 0.9S(0): the implied volatility
for the forward-start option conditional that S(T = 6m) < 0.9S(0)
64
Illustration VII. Implications

Conditional that spot moves up, the LSV model preserves the shape
of the volatility skew while the pure local volatility does not

Conditional that spot moves down, the pure local volatility implies
that the ATM volatility goes too high and the skew flattens unlike
the LSV model

The LSV is more closer to the actual dynamics!

65
Illustration VIII. Implied volatilities of options on the daily real-
ized variance of the S&P 500

200% 120%
Implied log-normal voltility

Implied log-normal voltility

160%
80%
120%

LSV, T=3m
80%
Local Vol, T=3m 40%
LSV, T=1year
40%
Local Vol, T=1year

0% 0%
23% 58% 92% 127% 162% 196% 231% 15% 37% 59% 81% 103% 125% 147%
K, Strike=K*ExpectedVariance(T) K, Strike=K*ExpectedVariance(T)

Left: Implied log-normal volatilities on options on the daily realized

variance of the S&P 500 with maturity T=3 month
Right: ... at T=1 year

LSV local volatility implies higher volatility of the realized variance ad

the vol-of-vol parameter can be ”tuned-up” to match the market
66
Illustration IX. Options on the VIX
Augment the model dynamics (22) with the third variable for the
realized quadratic variance of S(t):
 2
dI(t) = σ(loc,svj)(t−, S(t−))ϑ(t−, Y (t−)) dt + ν 2dN (t), I(0) = 0
Consider the expected variance realized over period [T, T + Tvix]:
"Z #
1 T +Tvix
I(T,
e T + Tvix) = E dI(t0)
Tvix T
where Tvix = 30/365.25 is the annualized tenor of the VIX

A call option on the VIX maturing at T is computed by:

 + 
C(T, K) = E I(T,
e T + Tvix) − K | I(T,
e T) = 0

Valuation:
i) Solve 2-d (!) backward problem for I(T, e T + Tvix) as function of
(S, Y )
ii) Compute G(t, S, Y ; T, S 0, Y 0) and evaluate C(T, K) by convolution
iii) Can price call with different strikes at a time
67
VIX Implied volatilities

24% 160% 1M 160% 2M

23% 140% 140%

VIX Futures

22% 120% LSV 120%

LSV LSV-Jump
LSV-Jump Market
21% Market 100% 100% LSV
LSV-Jump
Market
20% 80% 80%
1m 2m 3m 4m 90% 100% 110% 120% 130% 140% 150% 90% 100% 110% 120% 130% 140% 150%

120% 3M 120% 4M

100% 100%

80% LSV 80%

LSV
LSV-Jump
LSV-Jump
Market
Market
60% 60%
90% 100% 110% 120% 130% 140% 150% 90% 100% 110% 120% 130% 140% 150%

Conclusion: consistency with options on the SPX does not lead to

consistency with options on the VIX; Need extra flexibility for jumps
in volatility (time and/or space dependency)
68
Conclusions

I have presented theoretical and practical grounds for stochastic local

volatility models and highlighted details of model implementation

I am grateful to members of the quantitative group at Bank of Amer-

ica Merrill Lynch for their help and discussions during work on this
project

Thank you for your attention!

69
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