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The Local Volatility Surface: Unlocking the Information in Index Option Prices

Article  in  Financial Analysts Journal · July 1996

DOI: 10.2469/faj.v52.n4.2008

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 Goldman
Sachs Quantitative Strategies
Research Notes

December 1995 The Local Volatility Surface

Unlocking the Information in Index Option Prices

Emanuel Derman
Iraj Kani
Joseph Z. Zou
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Copyright 1995 Goldman, Sachs & Co. All rights reserved.

This material is for your private information, and we are not soliciting any action based upon it. This report is not to
be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer
or solicitation would be illegal. Certain transactions, including those involving futures, options and high yield
securities, give rise to substantial risk and are not suitable for all investors. Opinions expressed are our present
opinions only. The material is based upon information that we consider reliable, but we do not represent that it is
accurate or complete, and it should not be relied upon as such. We, our affiliates, or persons involved in the
preparation or issuance of this material, may from time to time have long or short positions and buy or sell securities,
futures or options identical with or related to those mentioned herein.

This material has been issued by Goldman, Sachs & Co. and/or one of its affiliates and has been approved by
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Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

SUMMARY

If you examine the structure of listed index options

prices through the prism of the implied tree model,
you observe the local volatility surface of the under-
lying index.

In the same way as fixed income investors analyze

the yield curve in terms of forward rates, so index
options investors should analyze the volatility smile
in terms of local volatilities.

In this report we explain the local volatility surface,

give examples of its applications, and propose sev-
eral heuristic rules of thumb for understanding the
relation between local and implied volatilities. In
essence, the model allows the extraction of the fair
local volatility of an index at all future times and
market levels, as implied by current options prices.
We use these local volatilities in markets with a pro-
nounced smile to measure options market senti-
ment, to compute the evolution of standard options
implied volatilities, to calculate the index exposure
of standard index options, and to value and hedge
exotic options. In markets with significant smiles, all
of our results show large discrepancies from the
results of the standard Black-Scholes approach.
Investors who buy or sell standard index options for
the exposure they provide, as well as market partici-
pants interested in the fair price of exotic index
options, should find interest in the deviations we
predict from the Black-Scholes results.
_______________________________

Emanuel Derman (212) 902-0129

Iraj Kani (212) 902-3561
Joseph Z. Zou (212) 902-9794

_______________________________

We are grateful to Barbara Dunn for comments on

the manuscript.

-2
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Table of Contents

THE IMPLIED VOLATILITY SURFACE............................................................... 1

THE IMPLIED VOLATILITY SURFACE BELIES THE BLACK-SCHOLES MODEL.. 2
THE LOCAL VOLATILITY SURFACE .................................................................. 4
THE ANALOGY BETWEEN FORWARD RATES AND LOCAL VOLATILITIES ........ 7
USING THE LOCAL VOLATILITY SURFACE ..................................................... 10
Obtaining the local volatilities ............................................................. 10
The correlation between index level and index volatility .................... 13
Implied distributions and market sentiment ........................................ 14
The future evolution of the smile ........................................................ 14
The skew-adjusted index exposure of standard options ...................... 17
The theoretical value of barrier options ............................................... 19
Valuing path-dependent options using Monte Carlo simulation ......... 20
APPENDIX: The relation between local and implied volatilities ................... 25

-1
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

THE IMPLIED VOLATILITY The market implied volatilities of standard equity index options com-
SURFACE monly vary with both option strike and option expiration. This struc-
ture has been a significant and persistent feature of index markets
around the world since the 1987 crash. Figure 1 shows a typical
implied volatility surface illustrating the variation of S&P 500
implied volatility with strike and expiration on September 27, 19951.
This surface, commonly called the “volatility smile,” changes shape
from day to day, but some general features persist.

The strike structure. At any fixed expiration, implied volatilities

vary with strike level. Almost always, implied volatilities increase
with decreasing strike – that is, out-of-the-money puts trade at
higher implied volatilities than out-of-the-money calls. This feature
is often referred to as a “negative” skew.

The term structure. For any fixed strike level, implied volatilities
vary with time to expiration. Often, long-term implied volatilities
exceed short-term implied volatilities.

In brief, there is a unique and generally different implied volatility

associated with any specific strike and expiration.

FIGURE 1.The implied volatility surface for S&P 500 index options as a
function of strike level and term to expiration on September 27, 1995.

1. Liquid listed options have discrete strikes and expirations, and so we have inter-
polated between them to create a continuous surface.

1
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

THE IMPLIED VOLATILITY Each implied volatility depicted in the surface of Figure 1 is the
SURFACE BELIES THE Black-Scholes implied volatility, Σ, the volatility you have to enter
BLACK-SCHOLES into the Black-Scholes formula to have its theoretical option value
MODEL match the option’s market price. Σ is the conventional unit in which
options market-makers quote prices. What does the varying volatility
surface for Σ tell us about the model and the world it attempts to
describe?

The primary feature of the Black-Scholes [1973] model of options val-

uation theory is that it is preference-free: since options can be hedged,
their theoretical values do not depend upon investors’ risk prefer-
ences. Therefore, an index option can be valued as though the return
on the underlying index is riskless.

A secondary feature of the theory is its assumption that returns on

stocks or indexes evolve normally, with a local volatility σ that
remains constant over all times and market levels. Figure 2 contains a
schematic representation of the index evolution in a binomial tree
framework2. The constant index level spacing in the figure corre-
sponds to the assumption of constant local return volatility. These
two features leads to the Black-Scholes formula C BS ( S, σ, r, T , K ) for
a call on an index at level S with a volatility σ, with strike K and time
to expiration T, when the riskless interest rate is r.

FIGURE 2.A schematic representation of index evolution in the Black-

Scholes model.

index
level

time

2. In mathematical terms, the evolution over an infinitesimal time dt is described by

the stochastic differential equation
dS
-------- = µdt + σdZ
S
where S is the index level, µ is the index’s expected return and dZ is a Wiener
process with a mean of zero and a variance equal to dt.

2
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

When options market makers quote an implied volatility Σ for an

option of a given strike and expiration, they are specifying the future
local volatility σ = Σ that you must enter into the Black-Scholes for-
mula to obtain the market price for the option, assuming that σ stays
constant over all times and market levels. By quoting two different
implied volatilities Σ1 and Σ2 for two different options they are attrib-
uting two different constant local volatilities to the same underlying
index, as illustrated in Figure 3. This belies the Black-Scholes pic-
ture. There is only one index underneath all the options and, for con-
sistency, it can only have one implied evolution process in
equilibrium. The market is using the Black-Scholes formula as a
mechanism for conveying information about its equilibrium prices,
but, in the act of quoting prices, belying the assumptions of the
model. As we shall point out later, this closely resembles the situa-
tion in bond markets, where traders quote bond prices by their yield
to maturity, but calculate them by using forward rates.

FIGURE 3. Schematic representation of the binomial index trees

corresponding to two options with different Black-Scholes implied
volatilities: (a) long-term option with low implied volatility; (b)
short-term option with high implied volatility.

(a) (b)

3
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

THE LOCAL VOLATILITY There is a simple extension to the strict Black-Scholes view of the
SURFACE world that can achieve consistency with the index market’s implied
volatility surface, without losing many of the theoretical and practi-
cal advantages of the Black-Scholes model.

Rational market makers are likely to base options prices on their

estimates of future volatility3. To them, the Black-Scholes Σ is,
roughly speaking, a sort of estimated average future volatility of the
index during the option’s lifetime. In this sense, Σ is a global measure
of volatility, in contrast to the local volatility σ at any node in the tree
of index evolution. Until now, theory has tended to disregard the dif-
ference between Σ and σ. Our path from now on is to accentuate this
difference, and deduce the market’s expectations of local σ from the
values it quotes for global Σ.

The variation in market Σ indicates that the average future volatility

attributed to the index by the options market depends on the strike
and expiration of the option. A quantity whose average varies with
the range over which it’s calculated must itself vary locally. The vari-
ation in Σ with strike and expiration implies a variation in σ with
future index level and time. In other words, the implied volatility
surface suggests an obscure, hitherto hidden, local volatility surface.

Assuming that options prices are efficient, we can treat all of them
consistently in a model that simply abandons the notion that future
volatilities will remain constant. Instead, we extract the market’s
consensus for future local volatilities σ(S,t), as a function of future
index level S and time t, from the spectrum of available options
prices as quoted by their implied Black-Scholes volatilities. Schemat-
ically, we replace the regular binomial tree of Figure 2 by an implied
tree4, as shown in Figure 4. Derman and Kani [1994] and, separately,
Dupire [1994] have shown that, if you know standard index options
prices of all strikes and expirations, then in principle you can
uniquely determine the local volatility surface function σ(S,t). A simi-
lar, though not identical, approach has been taken by Rubinstein
[1994].

3. This is not to say that this is the only important factor. In particular, traders will
also take hedging costs, hedging difficulties and liquidity into account, to name
only a few additional variables.
4. Our new model replaces the evolution equation in footnote 2 by
dS
-------- = µdt + σ(S, t) dZ
S
where σ(S,t) is the local volatility function whose magnitude depends on both
the index level S and the future time t.

4
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 4. The implied binomial tree.

index
level

time

In essence, our model assumes that index options prices (that is,
implied volatilities) are driven by the market’s view of local index vol-
atility in the future. We have shown that you can theoretically extract
this view of the local volatility σ(S,t) from standard options prices.
Readers familiar with the habits of options traders will realize that
thinking about future volatility is an intrinsic part of their job. Many
traders intuitively deduce future local volatilities from options prices.
Our model provides a more quantitative and exact way of accomplish-
ing this. Figure 5 displays the local volatility surface corresponding to
the implied volatility surface of Figure 1.

Our approach preserves many of the attractive facets of the Black-

Scholes model, while extending it to achieve consistency with market
options prices. The great advantage of the Black-Scholes model in a
trading environment is that it provides preference-free pricing. Its
inputs are current index levels, estimated dividend yields and inter-
est rates, most of which are determined and well-known. All the
model asks of a user is one implied volatility, which it translates into
an option price, an index exposure, and so on.

The implied tree model preserves this quality. In brief, all it asks of a
user is the implied Black-Scholes volatility of several liquid options of
various strikes and expirations. The model fits a consistent implied
tree to these prices, and then allows the calculation of the fair values
and exposures of all (standard and exotic) options, consistent with all
the initial liquid options prices. Since traders know (or have opinions
about) the market for current liquid standard options, this makes it
especially useful for valuing exotic index options consistently with
the standard index options used to hedge them.

5
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 5. The local volatility surface corresponding to the implied

volatilities of Figure 1.

In addition to the variation of the local volatility surface, there are

other factors that can complicate index options pricing, and so con-
tribute to a non-flat implied volatility surface. For example, volatility
itself has a stochastic component, and markets sometimes jump in a
manner inconsistent with the continuous evolution of implied tree
models. In addition, the Black-Scholes model ignores the effects of
transactions costs. All of these phenomena can contribute to the
smile. By using the implied tree model, we are assuming that the
variation of local volatility with market level and time is the domi-
nant contribution to the smile, and that other effects are less impor-
tant. We assume that options market makers think most about the
level volatility may take in the future. In this article we try to fully
exploit this small change in the Black-Scholes framework, otherwise
preserving the attractive and useful features of the model. We prefer
to use the more complex and less preference-free models involving
jumps and stochastic volatility only when our simpler approach
becomes inadequate.

6
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

THE ANALOGY The implied-tree approach to modeling the volatility smile stresses
BETWEEN FORWARD the use of local volatilities extracted from implied volatilities. Our
RATES AND LOCAL incentive to analyze value in terms of local quantities rather than
VOLATILITIES global averages is analogous to a similar historical development in
the analysis of fixed income securities more than a generation ago.

Suppose you know the quoted yield to maturity for all on-the-run
Treasury bonds, and you want to value an off-the-run (“exotic”) Trea-
sury bond whose coupon and maturity differ from those of any on-
the-run bond. Figure 6 displays the coupons, yields and one-year for-
ward rates for a hypothetical set of Treasury bonds. What yield to
maturity should you use to value the exotic Treasury?

FIGURE 6. Yields to maturity and one-year forward rates for a

hypothetical Treasury bond market. Coupons are paid annually. All
rates are compounded annually.

forward
maturity coupon price yield rate

1 year 5.00% 100 5.00% 5.00%

2 5.50 99.5 5.77 6.59

3 6.00 99.0 6.38 7.72

4 6.25 98.0 6.84 8.43

5 6.50 98.0 6.99 7.71

yield to maturity (%)

forward rate (%)
9.0

8.0

7.0

6.0

5.0

4.0

1 2 3 4 5
years

7
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

There is a close analogy between the dilemma in trying to value an

off-the-run Treasury bond by picking the “correct” yield to maturity
and the dilemma in trying to value an exotic option by picking the
“correct” implied volatility. In the Treasury bond market, each bond
has its own yield to maturity. The yield to maturity of a bond is actu-
ally the implied constant forward discount rate that equates the
present value of a bond’s coupon and principal payments to its cur-
rent market price. Similarly, in the index options market, each stan-
dard option has its own implied volatility, which is the implied
constant future local volatility that equates the Black-Scholes value
of an option to its current market price.

For off-the-run bond valuation, the correct and time-honored

approach is to eschew yield to maturity, and instead use the on-the-
run yield curve to deduce forward rates, and then use these forward
rates to discount the coupons of off-the-run bonds. Implied trees take
a similar approach to exotic options. They avoid implied volatility,
and instead use the volatility surface of liquid standard options to
deduce future local volatilities. Then, they use these local volatilities
to value all exotic options. We illustrate the similarities in Table 1.

TABLE 1. The analogy between forward rates and local volatilities

Aim To value an off-the-run To value an exotic index

Treasury bond: option:

Old Approach You used simple yield-to- You used simple implied
maturity to discount all volatility to calculate the
future coupons and prin- risk-neutral probability
cipal. of future payoff.

New Approach Use zero-coupon forward Use local volatilities con-

rates constructed from structed from liquid stan-
liquid Treasury bond dard options prices to
prices to discount all calculate the risk-neutral
future coupons and prin- probability of future pay-
cipal. off.

In the Treasury bond market, this approach makes sense if you’re a

hedger or arbitrageur. In that case, you’re interested in the value of
an off-the-run bond relative to the on-the-runs. Forward rates are the
appropriate way to determine relative value at the present time, no
matter what happens later. On the other hand, if you’re a speculator
you’re more interested in whether forward rates are good predictors

8
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

of future rates, and arbitrage pricing is less important. Similarly, in

the equity index options market, local volatilities are the appropriate
way to determine the value of an exotic option relative to standard
options, no matter what future levels volatility takes.

You can lock in forward rates by buying a longer-term bond and sell-
ing a shorter-term bond so that your net cost is zero. Analogously, you
can lock in forward (local) volatility by buying a calendar spread and
selling butterfly spreads with a zero net cost.

9
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

USING THE LOCAL Implied tree models of the skew are dynamical. They postulate a pro-
VOLATILITY SURFACE cess for future index evolution in which the local volatility function
σ(S,t) depends on S and t. The function σ() is determined by the con-
straint that the fair value of all standard options calculated from this
evolution process match current options market prices. Once σ(S,t) is
fixed, all future index evolution is known, and you can calculate a no-
arbitrage value for any derivative security in a manner consistent
with current options prices.

In this section we point out several areas where implied tree models
lead to significantly different, and sometimes counter-intuitive,
results when compared with the Black-Scholes model.

Obtaining the You need the following information to extract the local volatility sur-
local volatilities face at any instant:
1. the current value of the index;
2. the current (zero-coupon) riskless discount curve;
3. the values and ex dates of future index dividends; and
4. liquid standard options prices for a range of strikes and expira-
tions, or (more commonly) their Black-Scholes implied volatilities.

Figure 7 shows the data entry window of a Goldman Sachs program

for calculating local volatilities. The array of standard options’
implied volatilities has been displayed as an implied volatility sur-
face.

You can apply this procedure to any options market with good pricing
information for options of various maturities and strikes. Figure 8a
displays the local volatility surface of the S&P 500 index on Dec. 19,
1995, as extracted from the implied volatilities of Figure 7 using an
Edgeworth expansion technique due to Zou [1995]. Figure 8b shows
the Nikkei 225 index local volatility surface on Dec. 2, 1994. The neg-
ative skew in both the S&P and Nikkei markets produces surfaces for
which local volatility increases as market levels decrease.

These local volatilities represent the collective expectation of options

market participants, assuming the options prices are fair. It’s impor-
tant to note that these local volatilities are not necessarily good pre-
dictors of future realized volatility, just as forward interest rates are
not necessarily good predictors of future rates. Just as investors can
use long/short bond portfolios to lock in forward interest rates, so
they can use options to lock in future local volatilities.

10
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 7. Inputs to a program for calculating local volatilities. The plot

shows the implied volatility surface for the S&P 500 index on October
10, 1995. Estimated future dividends of the index are not displayed.

11
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 8.(a) The local volatility surface for the S&P 500 on Dec. 19, 1995.
(b) The local volatility surface for the Nikkei 225 on Dec. 2, 1994. The
Nikkei index level is shown in multiples of 100.

(a)

(b)

12
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

The correlation The local volatility surface indicates the fair value of local volatility
between index level at future times and market levels. The most striking feature of Fig-
and index volatility ure 8 is the systematic decrease of local index volatility with increas-
ing index level. This implied correlation between index level and
local volatility is essentially responsible for all of the qualitative fea-
tures of our results below.

The variation in S&P 500 local volatility displayed in Figure 8a is

generally greater than the variation in implied volatility in Figure 7
that produced it. For skewed options markets, we note the following
heuristic rule5:

Rule of Thumb 1: Local volatility varies with

market level about twice as rapidly as implied vol-
atility varies with strike.

Figure 9 illustrates this relationship. For theoretical insight, see the

Appendix, and also Kani and Kamal [1996].

FIGURE 9.In the implied tree model, local volatility varies with index
level approximately twice as rapidly as implied volatility varies
with strike level.

local

volatility

implied

level

5. The three rules of thumb that appear below apply to short and intermediate term
equity index options, where the correlation between index level and volatility is
most pronounced and the assumption of approximately linear skew seems to be
good. For longer term options, other factors, such as stochastic volatility or vola-
tility mean reversion, may start to blur the effects of correlation that we have
encapsulated in these three rules.

13
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Implied distributions If you can estimate future index dividend yields and growth rates,
and market sentiment you can use the local volatility surface to simulate the evolution of
the index to generate index distributions at any future time. Figure
10 shows the end-of-year S&P 500 distributions implied by liquid
options prices during mid-July 1995, a turbulent time for the U.S.
equity market. In generating these distributions we have assumed
an expected annual growth rate of 6% and dividend yield of 2.5% per
year.

On Monday, July 17, the S&P 500 index closed at a record high of
562.72. On Tuesday, July 18, the Dow Jones Industrials Index
dropped more than 50 points and the S&P closed at 558.46. On
Wednesday, July 19, the Dow Jones fell about another 57 points, and
the S&P closed at 550.98. The shift in market sentiment during these
three days is reflected in the changing shapes of the distributions.
For instance, a shoulder at the 550 level materialized on July 18,
indicating a more negative view of the market. By July 19, a peak at
the 480 level became apparent.

Investors whose views of future market distributions differ from that

implied by options prices can take advantage of the differences by
buying or selling options.

The future evolution of Once fitted to current interest rates, dividend yields and implied vol-
the smile atilities, the implied tree model produces a tree of future index levels
and their associated fair local volatility, as implied by options prices.
Figure 11 displays a schematic version of the implied tree for a nega-
tively skewed market. with its origin at the time labeled current.
Assuming the market’s perception of local volatility remains
unchanged as time passes and the index moves, we can use these
local volatilities to calculate the dependence of implied volatility on
strike at future times. If, at some time labeled later in Figure 11, the
index moves to either of the levels labeled up or down, the evolution
of the index is described by the subtrees labeled up or down. This is
valid provided no new information about future volatility, other than
a market level move, has arrived between the time the initial tree
was built and the time at which the index has moved to the start of a
new subtree.You can use the up or down tree to calculate fair values
for options of all strikes and expirations at time later. You can then
convert these prices into Black-Scholes implied volatilities, and so
compute the fair future implied volatility surfaces and skew plots.

14
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 10.Implied S&P 500 distributions on Dec. 31, 1995, based on

S&P 500 implied volatilities on July 17, 18 and 19, 1995. We assume a
growth rate of 6% and dividend yield of 2.5% to year end.

Probability (%)

12.00
7/17/95
9.00
S&P close 562.72
6.00

3.00

0.00
450

500

550

600

650

700
400

12.00
7/18/95
9.00
S&P close 558.46
6.00

3.00

0.00
450

500

550

600

650

700
400

12.00
7/19/95
9.00
S&P close 550.98

6.00

3.00

0.00
450

500

550

600

650

700
400

Index Level

15
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 11. Schematic illustration of the implied tree and the trees
contained within it in a negatively skewed market. Larger spacing
depicts higher local volatility.

index
level up
lower volatility
subtree
down higher volatility
subtree

current later time

Let’s look at an example for a negatively skewed index like the S&P
500. To be specific, consider standard options on an index whose cur-
rent level is 100, with a riskless interest rate of 7% and a dividend
yield of 2%. We assume annual at-the-money implied volatility to be
25%, with a hypothetical constant negative skew of one volatility
point decrease for every ten-point increase in strike. For simplicity
we assume that all these rates, yields and volatilities are indepen-
dent of maturity or expiration – that is, all term structures are flat.
Figure 12 shows the fair implied volatility skew for one-year options
six months after the initial implied tree was constructed. You can see
that, for negative skews, the implied volatility of an option with any
particular strike tends to move down as the market moves up.

Here’s another heuristic rule for implied tree models:

Rule of Thumb 2: The change in implied volatility

of a given option for a change in market level is
about the same as the change in implied volatility
for a change in strike level.

For example, if the skew is such that a one-point change in strike

leads to a half-percentage-point change in implied volatility, then so
does a one-point change in market level. If you know the observed
skew at a fixed market level, then you know what happens to a given
option’s value when the market moves. For further elaboration, see
the Appendix.

16
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 12. Evolution of the smile: the smile at a variety of index

levels, assuming an initial index level of 100. The line labeled 100 is
the initial smile. Other lines represent the implied tree’s fair skews
at different market levels six months in the future, as indicated by
the corresponding labels.

35 60
60
80
60
80
60 initial smile
implied volatility (%)
30 100 80 60
120 100 80 60
100 80 60
120
140 100 80 60
120 100 80 60
140 120 80 60
25 100 60
140 120 100 80
140 120 100 80
140 120 100 80
140 120 100
20 140 120 100
140 120
140 120
140
140

15

50 60 70 80 90 100 110 120 130 140 150

strike

The skew-adjusted Implied tree models are constrained to fit current liquid standard
index exposure of options prices. As we illustrated in Figure 11, for negatively skewed
standard options volatility markets like the S&P 500, local volatility falls as the index
rises. Now, implied volatility is a global average over local volatilities.
Therefore, for any particular option, implied Black-Scholes volatility
is anti-correlated with the index level, falling as the index rises and
rising as it falls. We illustrate this point in Figure 13, where the evo-
lution of the initial value of a call, C, as the index moves up or down,
is shown in both the Black-Scholes and implied tree models

In the notation of Figure 13, the index exposure of the call in the
Black-Scholes model is proportional to C u – C d . In the implied tree
model the exposure is proportional to C' u – C' d . But the negative cor-
relation of volatility with index level in the implied tree means that
C' u < C u and C' d > C d , so that ( C' u – C' d ) < ( C u – C d ) . The exposure of
the call in the implied tree model with negative skew is consequently

17
Goldman
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QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 13. The delta exposure of a call option in the Black-Scholes

model and the implied tree model. Cu(d) denotes the value of the call C
after an upward(downward) index move in a constant volatility. C'u(d)
denotes the value of the same call in the implied tree model.
Black-Scholes tree implied tree

Black-Scholes tree implied tree

C'u
Cu lower volatility
constant C
C volatility subtree
subtrees C'd higher volatility
Cd
subtree

lower than it would have been in a Black-Scholes world with flat vol-
atility. The implied-tree exposure of a put under the same circum-
stances is also lower (that is, more negative) than the corresponding
Black-Scholes exposure.

In the implied tree model, a rise in index level influences the value of
a call option in two ways. First, the call moves deeper into the money.
Second, the volatility of the call decreases because of the correlation
between index and local volatility. With this in mind, you can use the
Black-Scholes formula and Rule of Thumb 2, as explained in the
Appendix, to derive the following heuristic rule for the option’s expo-
sure:

Rule of Thumb 3: The correct exposure ∆ of

an option is approximately given by
∆ = ∆ BS + V BS × β

where ∆BS is the Black-Scholes exposure (in

dollars per index point), VBS is the Black-
Scholes volatility sensitivity (in dollars per vol-
atility point), and β is the observed sensitivity
of implied volatility to strike level (in volatility
points per strike point). β is negative in options
markets where implied volatility decreases
with strike.

18
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Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Table 2 illustrates the effect of the skew on a call’s index exposure

using the above rule of thumb. The market parameters chosen corre-
spond roughly to those of the S&P 500. The rule-of-thumb exposure is
48% of the underlying index, 11 percentage points lower than the
naively-calculated Black-Scholes exposure of 59%. This is a signifi-
cant difference.

TABLE 2. Theeffect of the smile on the index exposure of a call option

(See Rule of Thumb 3)

Market Call Option Exposure

Index 600 Strike 600 ∆BS 0.59

Dividend 3% Expiration 1 year V BS × β -0.11

yield

Volatility 13% Black-Scholes 38.4 Rule-of- 0.48

(a-t-m) value thumb ∆

Skew -0.05* Black-Scholes 2.23**

slope β volatility
sensitivity V

Riskless 6%
rate

* in percentage points per index strike point.

** in dollars per volatility point.

The theoretical value of The theoretical value of a barrier option depends on the risk-neutral
barrier options probability of the index being in-the-money at expiration, but not
having crossed the barrier during the option’s lifetime. This probabil-
ity is very sensitive to volatility levels in general, and to the volatility
skew in particular. The traditional, and widely used, analytical for-
mula [Merton 1973] for barrier options applies only in the absence of
skew, and is not a good guide when appreciable skews exist.

We illustrate this examining at a one-year up-and-out European-

style call option on an index with strike at 100% of the index level
and barrier at 130%. Figure 14 shows the hypothetical implied vola-
tility skew we use to illustrate the valuation. We also assume a risk-
less annual interest rate of 5% and zero dividend yield.

19
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Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 14. A hypothetical volatility skew for options of any expiration.

We assume a constant riskless discount rate of 5% and a zero dividend
yield. The arrows show the strike (100) and barrier (130) level of the up-
and-out option under consideration.

25.00

20.00
implied volatility

15.00

10.00

5.00
0.00 50.00 100.00 150.00 200.00

strike (% of spot)

Figure 15 shows the variation in the theoretical value of the knock-

out call as a function of implied volatility in a world with no skew.
The value of the call peaks at 5.99% when the volatility is about
9.6%. Any further increase in volatility causes a decrease in call
value because the additional likelihood of knockout before expiration
outweighs the additional probability of finishing in-the-money.

According to our implied tree model, constrained to fit the skew of

Figure 14, the up-and-out option is worth 6.46% of the current index
value. This is greater than any value in the skewless world of Figure
15. There is no single value of volatility in a skewless model that can
account for the implied tree call value. No amount of intuition can
lead you to guess the “right” volatility value to insert into the flat-vol-
atility “wrong” model to reproduce the “right” knockout call value
caused by the skew.

Valuing path- Path-dependent options contain embedded strikes at multiple mar-

dependent options ket levels, and are consequently sensitive to local volatility in multi-
using Monte Carlo ple regions. When implied volatility varies with strike or expiration,
simulation no single constant volatility is correct for valuing a path-dependent
option. However, you can simulate the index evolution over all future
market levels and their corresponding local volatilities to calculate

20
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 15. Theoretical value of an up-and-out, at-the-money,

European-style call option as a function of volatility in a flat-
volatility world. Strike = 100; barrier = 130; dividend yield = 0;
annual discount rate = 5%.

6.00

5.00

call value (% of spot)

4.00

3.00

2.00

1.00

0.00 10.00 20.00 30.00

volatility

the fair value of the option. We illustrate this approach for a Euro-
pean-style lookback call and put. The method is general and can be
applied to Asian options, as well as other path-dependent derivative
instruments.

Now consider a one-year lookback call or put with a three-month

lookback period on the strike. The call and put payoffs at expiration
are max [ S' – S min ] and max [ S max – S' ] respectively, where S' is the
terminal index level and Smin (Smax) is the lowest (highest) level the
index reaches during the first three months of the option’s life. We
value the securities by simulating index paths whose local volatilities
are extracted from the relevant implied volatility smile. For each
path we calculate the present value of the eventual payoff of the look-
back call, averaging over all paths to obtain the current value of the
call. We duplicate this procedure to value the lookback put.

Figure 16 shows the dominant index evolution paths – the paths that
contribute the most value – to the lookback calls and puts. A domi-
nant path for a lookback call sets a low strike minimum during the
first three months, and then rises to achieve a high payoff. The theo-
retical value of the call is determined by (i) the likelihood of setting a
low strike, and then, the strike having been fixed and the lookback

21
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 16.Dominant paths contributing to the value of a lookback call and

put. The local volatilities are negatively skewed.

index
level dominant path
for lookback call
low volatility
Smax
region

dominant path
for lookback put
Smin high volatility
region

end of expiration time

lookback
period

option having become a standard option, (ii) the subsequent volatility

of the index. Similarly, a dominant path for a lookback put sets a high
initial strike and then drops. Its value is determined by the likeli-
hood of a high strike and the subsequent index volatility.

In the implied tree model with a negative volatility skew, higher

strikes and index levels correlate with lower index volatility. There-
fore, the dominant path for a lookback call is more likely to have an
advantageously low strike Smin, and a high subsequent volatility.
Conversely, the dominant path for a lookback put is more likely to
have a disadvantageously low strike Smax, and a low subsequent vol-
atility. Therefore, in a negatively skewed world, lookback puts are
worth relatively less, and lookback calls more. When options values
are quoted in terms of their Black-Scholes (unskewed) implied vola-
tilities, lookback calls will have higher implied volatilities than look-
back puts.

For illustration, we now assume a hypothetical index level of 100, a

dividend yield of 2.5%, and a riskless rate of 6% per year. The index
has a negative skew that is assumed to be independent of expiration:
at-the-money implied volatility is 15%, and decreases by 3 percent-

22
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

age points for each increase of 10 index strike points. Using Monte
Carlo simulation, we find the fair value of the lookback call to be
10.8% of the index, and the value of the lookback put to be 5.8%. In
the framework of an unskewed, Black-Scholes index, these values
correspond to an implied volatility of 15.6% for the lookback call and
13.0% for the lookback put.

You can use the same method to calculate the deltas of lookback
options. Figure 17 compares the implied-tree deltas with the Black-
Scholes deltas6 for the one-year lookback call described above, for a
range of minimum index levels previously reached when the index
level is currently at 100. The Black-Scholes deltas are calculated at
the Black-Scholes implied volatility of 15.6% that matches the value
obtained by Monte Carlo simulation value over the skewed local vola-
tilities.

FIGURE 17.The delta of a one-year call with a three-month lookback

period that has identical prices in the implied tree model and the
Black-Scholes world with no skew. The current market level is
assumed to be 100.

implied tree Black-Scholes

1.00

0.80

0.60
delta

0.40

0.20

0.00

-0.20
50.00 60.00 70.00 80.00 90.00 100.00

minimum index level reached

6. The expression “Black-Scholes delta” is shorthand for the delta in a Black-Scholes

world – that is, a world where local volatility is constant, independent of future
time and future index level. Similarly, “Black-Scholes implied volatility” is short-
hand for the constant local volatility in a Black-Scholes world that results in a
theoretical value that matches the dollar value of the option.

23
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Note that the delta of the lookback call is always lower in the implied
tree model than in the Black-Scholes model. This mismatch in model
deltas occurs because, in the implied tree model, the option’s sensitiv-
ity to volatility also contributes to its index exposure through the cor-
relation between volatility and index level (see Rule of Thumb 3). The
mismatch is greatest where volatility sensitivity is largest, that is,
where the minimum index level is close to the current index level.
The mismatch is correspondingly smallest when the lowest level pre-
viously reached is much lower than the current index level, since the
lookback is effectively a forward contract with zero volatility sensitiv-
ity. The fact that the theoretical delta of an at-the-money lookback
call is negative – to hedge a long call position you must actually go
long the index – is initially quite astonishing to market participants.

A similar effect holds for lookback puts, whose implied-tree deltas are
also always numerically lower (that is, negative and larger in magni-
tude) than the corresponding Black-Scholes deltas.

24
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

APPENDIX: The relation In this appendix we provide some insight into our three rules of
between local and thumb. Our treatment is intuitive; for a more rigorous approach see
implied volatilities Kani and Kamal [1996].

We restrict ourselves to the simple case in which the value of local

volatility for an index is independent of future time, and varies lin-
early with index level, so that

σ ( S ) = σ 0 + βS for all time t (A 1)

If you refer to the variation in future at-the-money local volatility as

the “forward” volatility curve, then you can call this variation with
index level the “sideways” volatility curve.

Consider the implied volatility Σ(S,K) of a slightly out-of-the-money

call option with strike K when the index is at S. Any paths that con-
tribute to the option value must pass through the region between S
and K, shown shaded in Figure 18. The volatility of these paths dur-
ing most of their evolution is determined by the local volatility in the
shaded region.

FIGURE 18. Index evolution paths that finish in the money for a call
option with strike K when the index is at S. The shaded region is
the volatility domain whose local volatilities contribute most to the
value of the call option.

index
level

strike K

spot S

expiration time

25
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Because of this, you can roughly think of the implied volatility for the
option of strike K when the index is at S as the average of the local
volatilities over the shaded region, so that

∫
1
Σ ( S, K ) ≈ --------------- σ ( S' ) dS'
K–S
S
(A 2)

By substituting Equation A1 into Equation A2 you can show that

β
Σ ( S, K ) ≈ σ 0 + --- ( S + K ) (A 3)
2

Equation A3 shows that, if implied volatility varies linearly with

strike K at a fixed market level S, then it also varies linearly at the
same rate with the index level S itself. This is Rule of Thumb 2 on
page 16. Equation A1 then shows that local volatility varies with S at
twice that rate, which is Rule of Thumb 1 on page 13. You can also
combine Equation A1 and Equation A3 to write the relationship
between implied and local volatility more directly as

β
Σ ( S, K ) ≈ σ ( S ) + --- ( K – S ) (A 4)
2

If C BS ( S, Σ ( S, K ), r, t, K ) represents the Black-Scholes formula for the

value of a call option in the presence of an implied volatility surface
Σ ( S, K ) , then its exposure is given by

dC BS ∂C BS ∂C BS ∂Σ
∆ = = + ⋅
dS ∂S ∂Σ ∂S
(A 5)
∂C BS ∂C BS ∂Σ
≈ + ⋅
∂S ∂Σ ∂K

∂Σ ∂Σ
We have used the fact that ≈ , a consequence of Equation A3, in
∂S ∂ K
writing the last identity. Equation A5 is equivalent to Rule of Thumb
3 on page 18.

26
Goldman
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QUANTITATIVE STRATEGIES RESEARCH NOTES

REFERENCES

Black, F and M. Scholes (1973). The Pricing of Options and Corporate

Liabilities. J. Political Economy, 81, 637-59.

Derman, E. and I. Kani (1994). Riding On A Smile, RISK, 7 (Febru-

ary), 32-39.

Dupire, B. (1994). Pricing With A Smile, RISK, 7 (January), 18-20.

Kani, I and M. Kamal (1996). Goldman Sachs Quantitative Strategies

Research Notes, forthcoming.

Merton, R.C. (1973). Theory of Rational Option Pricing, Bell Journal

of Economics and Management Science, 4 (Spring), 141-183.

Rubinstein, M. (1994). Implied Binomial Trees, The Journal of

Finance, 49 (July), 771-818.

Zou, J. (1995). Goldman Sachs internal notes, unpublished.

27
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

SELECTED QUANTITATIVE STRATEGIES PUBLICATIONS

June 1990 Understanding Guaranteed Exchange-Rate Contracts

In Foreign Stock Investments
Emanuel Derman, Piotr Karasinski
and Jeffrey S. Wecker

January 1992 Valuing and Hedging Outperformance Options

Emanuel Derman

March 1992 Pay-On-Exercise Options

Emanuel Derman and Iraj Kani

June 1993 The Ins and Outs of Barrier Options

Emanuel Derman and Iraj Kani

January 1994 The Volatility Smile and Its Implied Tree

Emanuel Derman and Iraj Kani

May 1994 Static Options Replication

Emanuel Derman, Deniz Ergener
and Iraj Kani

May 1995 Enhanced Numerical Methods for Options

with Barriers
Emanuel Derman, Iraj Kani, Deniz Ergener
and Indrajit Bardhan

28

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