Semi-parametric pricing and hedging of claims

on price and volatility

Matt Lorig
Based on work with Peter Carr and Roger Lee
Department of Applied Mathematics, University of Washington

Pricing of exotic derivatives: parametric approach

The parametric approach to pricing exotic derivatives involves:
writing a parametric model for an underlying S (e.g., Heston,

SABR, Hull-White, exponential Levy),

calibrating the model to liquid calls C(K) and puts P (K),

using the model and the obtained parameters to price exotics

(either analytically or via Monte Carlo).

This approach has a number of shortcomings:

parametric models typically limited to those that produce

closed-form call/put prices,

parametric models cannot fit market data,

the models must be re-calibrated frequently; calibration is

time-consuming.

Pricing of exotic derivatives: non-parametric approach

The non-parametric approach to pricing exotics involves:
writing a non-parametric model for an underlying S (e.g., S is

a diffusion),

deriving upper and lower bounds for exotic derivative prices

relative to calls C(K) and puts P (K),

(there is a vast and growing literature on non-parametric

pricing and martingale optimal transport, which I will not

attempt to review here)

This approach has a number of shortcomings:

pricing and hedging strategies are often difficult to implement,
upper and lower bounds may be too far apart for use in

practice.

Pricing of exotic derivatives: semi-parametric approach

The semi-parametric approach we follow can be summed up as
follows:
write a semi-parametric model for an underlying S with

minimal structure,

use the structure to give unique prices and hedges for exotics

relative to liquid calls C(K) and puts P (K).

This approach has a number of advantages:

compared to parametric models, semi-parametric models

are more flexible and more likely to fit market data,

frequent (re-)calibration not needed,

compared to non-parametric models, pricing and hedging

strategies are easier to implement

unique prices (rather than price bounds) are obtained

Basic assumptions and notation

Throughout this talk, we make the following assumptions:
no arbitrage,

no transactions costs,
zero interest rates.

We fix a maturity date T .

Denote by S = (St )0tT the price of a strictly positive risky asset.
Denote by X = (Xt )0tT the log price: Xt = log St .
Under the above assumptions, put and call prices are given by
P (K) = E(K ST )+ ,

C(K) = E(ST K)+ .

Here, E denotes expectation with respect to the markets chosen

pricing measure P.
We assume a call and/or put trades at every strike K (0, ).

Non-parametric pricing of European options

Carr and Madan (1998) show that, if f can be expressed as the
difference of convex functions, then for any R+ we have


f (s) = f () + f () (s )+ ( s)+
Z
Z

+
dKf (K)(s K)+ .
dKf (K)(K s) +
+

Replacing s with ST , setting = S0 , and taking an expectation

E f (ST ) = f (S0 ) +

S0

dKf (K)P (K) +

0

dKf (K)C(K),

S0

Takeaway: the price of any European claim Ef (ST ) can be

expressed relative to puts and calls on ST .
This result is completely model-free; it makes no assumptions on
the S process.
To price exotics, we will need to impose some structure on S.

Semi-parametric model
We assume the S process satisfies
dSt = t St dWt ,

S0 > 0.

Here, W = (Wt )0tT is a Brownian motion with respect to the

pricing measure P and filtration F = (Ft )0tT .
The model is semi-parametric; we assume only:
the volatility process = (t )0tT is right-continuous,

F-adapted and satisfies

Z

W.

T
0

t2 dt < c < ,

Note that may experience jumps and is not required to be

Markovian.

Types of claims we consider

A simple application of It
os Lemma yields
dXt = 21 t2 dt + t dWt ,

X0 = log S0 .

We wish to price and hedge on X and hXi of the form

European-style
knock-out :
knock-in :
rebate :

(XT , hXiT ),

I{ >T } (XT , hXiT ),

I{ T } (XT X , hXiT hXi ),

I{ T } (hXi ),

where is the first exit time of some interval I

= inf{t 0 : Xt
/ I},

:= T,

and is some payoff function. Examples:

p
volatility swap: (XT , hXiT ) = hXiT
T X0
realized Sharpe ratio: (XT , hXiT ) = X
hXiT

Pricing exponential claims

We will use exponential claims to construct more general claims
exponential claim payoff :

eiXT +ishXiT

To this end, the following proposition will be useful.

Proposition
Let , s C. Define u : C2 C as either of the following


q
1
1
2
u(, s) = i 2 4 i + 2is .
Then we have
E eiXT +ishXiT = ei(u)X +ishXi E eiuXT .
Note: The value of E eiuXT fixed by call/put prices and the
factor ei(u)X +ishXi is F -measurable.

Sketch of proof.
For simplicity, assume = 0. Note that
XT |FT N(m, v 2 ),

v 2 = hXiT .

m = 21 hXiT ,

where FT denotes the sigma-algebra generated by (t )0tT . Thus

E eiXT +ishXiT = E eishXiT E[eiXT |FT ]
= E E[e(is(
= E E[e((u

2 +i)/2)hXi

|FT ]

2 (,s)+iu(,s))/2)hXi

= E E[eiu(,s)XT |FT ]

= E eiu(,s)XT ,
where we have used



q
1
1
2
u(, s) = i 2 4 i + 2is .

|FT ]

Hedging exponential claims

Proposition
Fix , s, C and define
Nt := ei(u(,s))Xt +ishXit ,

Qt := Et eiu(,s)XT .

Consider a portfolio process = (t )0tT , which consists of:

Nt European claims Qt with payoff eiu(,s)XT ,

i(u)Nt Qt
St

shares of the stock St ,

(i( u(, s))Nt Qt ) bonds Bt .

The portfolio is self-financing



i( u(, s))Nt Qt
dSt
dt = Nt dQt +
St


+ i( u(, s))Nt Qt dBt ,
and it replicates the exponential claim: T = eiXT +ishXiT .

Proof.
By construction, we have


i( u)Nt Qt
t = Nt Qt +
St
St


+ i( u(, s))Nt Qt Bt = Nt Qt .
At time T , it is easy to see that replicates the exponential claim
T = NT QT = ei(u(,s))XT +ishXiT ET eiu(,s)XT
= eiXT +ishXiT .
To establish that is self-financing we compute
dt = Nt dQt + Qt dNt + d[N, Q]t


i( u(, s))Nt Qt
dSt .
= Nt dQt +
St
The second line follows from a lot of algebra (which we omit).

Power-exponential claims
To price power-exponential claims
iXT +ishXiT
EXTn hXim
= (i )n (is )m EeiXT +ishXiT
Te

= (i )n (is )m Eeiu(,s)XT

= E(i )n (is )m eiu(,s)XT ,

The value of E(i )n (is )m eiu(,s)XT fixed by call/put prices.
To replicate power exponential claims
iXT +ishXiT
XTn hXim
= (i )n (is )m eiXT +ishXiT
Te


Z T
n
m
dt (, s)
0 (, s) +
= (i ) (is )

= (i )n (is )m 0 (, s) +

(i )n (is )m dt (, s),

where (, s) replicates eiXT +ishXiT .

Single-barrier knock-in-style claims

Let us define L , the first hitting time of X to level L

L := inf{t 0 : Xt = L},

L = L T.

For simplicity, assume L < X0 .

Consider a single-barrier knock-in style claim , whose value is
E I{L T } (XT XL , hXiT hXiL ).
If L T , the option has payoff (XT XL , hXiT hXiL ).
If L > T , the option pays nothing.

Single-barrier knock-in exponential claim

Proposition
Fix L < X0 . Let , s C and let u u(, s) be defined previously


q
1
1
2
u(, s) = i 2 4 i + 2is .
To hedge a knock-in exponential payoff
I{L T } e

i(XT X )+is(hXiT hXi )

L

hold one european claim with payoff

Lki (XT ; , s) = I{XT <L} e(1iu)(XT L) + I{XT L} eiu(XT L) .
If and when the barrier is hit, hedge the claim using the portfolio
(, s) (previously discussed).

Proof.
If L > T then XT > L and
Lki (XT ; , s) = I{XT <L} e(1iu)(XT L) + I{XT L} eiu(XT L)
= 0.
Thus, the European claim Lki (XT ; , s) and the knock-in claim
pay nothing.
If L T then one can show
EL Lki (XT ; , s) = EL ei(XT XL +is(hXiT hXiL .
Thus, one can exchange the European claim Lki (XT ; , s) for the
portfolio that hedges the exponential claim at no cost.

Example: knock-in fractional power claims on hXiT

Proposition
For any 0 < r < 1 and L < X0 we have
EI{L T } (hXiT hXiL )r = Eg(XT ),
where the function g is given by
Z

r
1  ki
ki
g(XT ) =
dz r+1 L (XT ; 0, 0) L (XT ; 0, iz) .
(1 r) 0
z
Here, is the Euler Gamma function and Lki (XT ; , s) is as
previously defined
Lki (XT ; , s) = I{XT <L} e(1iu)(XT L) + I{XT L} eiu(XT L)

Proof
We have the following identity
Z

1 
r
dz r+1 1 ezv ,
vr =
(1 r) 0
z

v 0,

0 < r < 1.

Hence, we compute
EI{L T } (hXiT hXiL )r
Z


r
1
z(hXiT hXi )
L
=
dz r+1 EI{L T } 1 e
(1 r) 0
z
Z


1
r
dz r+1 E Lki (XT ; 0, 0) Lki (XT ; 0, iz)
=
(1 r) 0
z
= Eg(XT ),
where checking the conditions of Fubinis theorem is non-trivial.

Figure 1: We plot the function g(log )

qthat prices a single-barrier
knock-in claim on volatility: I{L T } hXiT hXiL The following

parameters are fixed: eL = 90 and r = 1/2. The vertical line is placed at

the knock-in barrier eL = 90.

Single-barrier knock-out-style claims

Let us define L , the first hitting time of X to level L

L := inf{t 0 : Xt = L},

L = L T.

For simplicity, assume L < X0 .

Consider a single-barrier knock-out style claim , whose value is
E I{L >T } (XT , hXiT ).
If L > T , the option has payoff (XT , hXiT ).
If L T , the option pays nothing.

Theorem
Fix L < X0 . The following trading strategy replicates a single
barrier knock-out claim with payoff
Single barrier knock-out :

I{L >T } (XT , hXiT ).

At time 0 hold a European-style claim with payoff

ko
L (XT , hXiT ) := I{XT >L} (XT , hXiT )

I{XT <L} eXT L (2L XT , hXiT ).

If and when the claim knocks out, clear to position in

ko
L (XT , hXiT ) at no cost.

Proof.
If L > T then XT > L and
ko
L (XT , hXiT ) := I{XT >L} (XT , hXiT )

I{XT <L} eXT L (2L XT , hXiT )

= (XT , hXiT ),

I{L >T } (XT , hXiT ) = (XT , hXiT )

Thus, the knock-out claim and the claim ko

L (XT , hXiT ) both pay
(XT , hXiT ).
If L T , one can show
EL ko
L (XT , hXiT ) = 0.
Thus, at time L the barrier claim knocks out and one can clear
the position in ko
L (XT , hXiT ) at time L at no cost.

Pricing knock-out exponential claim

We wish hedge the knock-out exponential claim
I{L >T } eipXT +ishXiT
We know from previous theorem that


EI{L >T } eipXT +ishXiT = E h(XT , hXiT ) g(XT , hXiT ) ,
where the functions h and g are given by
h(XT , hXiT ) = I{XT >L} eipXT +ishXiT ,

g(XT , hXiT ) = I{XT <L} eXT L eip(2LXT )+ishXiT .

We would like to relate E (h(XT , hXiT ) g(XT , hXiT )) to a

claim written on X only: Ef (XT ).

Rough idea: use Fourier transforms

Introduce H(x) = I{x>0} , the Heaviside function. We have
Eh(XT , hXiT ) = EH(XT L)eipXT +ishXiT
Z
b p)ei(p)L eiXT +ishXiT
d H(
=E
Z R
b p)ei(p)L Eeiu(,s)XT
d H(
=
R

= Ef (XT ),

b is the Fourier transform of H and

where H
Z
b p)ei(p)L eiu(,s)XT .
f (XT ) :=
d H(
R

Note: In fact, we must work with a smoothed version of H in

order to pull the E out of the Fourier integral and then take a limit.

We plot the function fn (log ), which, in the limit as n ,

prices a single barrier knock-out power/exponential claim
I{L >T } XTj hXikT eipXT +ishXiT
In both plots, the following parameters are fixed: L = log 90,
X0 = log 110, p = 0, s = 0, j = 0, k = 1, n = 25. The vertical
dashed lines are placed at eL = 90 and S0 = eX0 = 110. Note that
with (p, s, j, k) as chosen, the European payoff function plotted
above prices a single barrier knock-out variance swap, which pays
I{L >T } hXiT .

Single-barrier rebate claims

Let us define L , the first hitting time of X to level L

L := inf{t 0 : Xt = L},

L = L T.

For simplicity, assume L < X0 .

Consider a single-barrier rebate claim , whose value is
E I{L T } (hXiL ).
If L T , the option has payoff (hXiL ).
If L > T , the option pays nothing.

Single barrier rebate exponential claim

Theorem
The following trading strategy replicates the single barrier rebate
exponential claim
Single barrier rebate exponential :

I{L T } e

ishXi

At time zero, buy one claim with payoff

Lrb (XT , hXiT ; s) = eiv(s)(XT L)+ishXiT ,
q


v(s) = i 12 14 2is ,
and sell one single barrier knock-out claims with payoff
I{H >T } Lrb (XT , hXiT ; s).

Proof.
If L > T the rebate claim pays nothing. The hedging portfolio
also pays nothing as
Lrb (XT , hXiT ; s) I{L >T } Lrb (XT , hXiT ; s) = 0.
If L T the rebate claim pays eishXiL at time L . The
knock-out claim knocks out at time L . And one can show
EL Lrb (XT , hXiT ; s) = eishXiL .
We know how to relate European-style claims (XT , hXiT ) and
knock-out claims I{L >T } (XT , hXiT ) to claims written on X
only. Thus we can relate the value of a relate exponential claim
ishXi
L to the value of a European claim Ef (XT ) for
I{L T } e
some function f .

Figure 2: We plot the function prices a single barrier rebate variance swap
I{H T } hXiH . Left: the solid, dashed, and dotted lines correspond to
eX0 = {100, 1001.25 , 1001.50 }, respectively. The vertical dashed line is
placed at the barrier eL = 90. Right: the solid, dashed, and dotted lines
correspond to eX0 = {80, 802/3 , 801/3 }, respectively. The vertical dashed
line is placed at the barrier eU = 90.

Shortcomings of the model

There are a few short-comings of our semi-parametric model:
dSt = t St dWt .
First, we have assume W . This implies a symmetric implied
volatility smile, which is reasonable for currency markets, but is
not usually satisfied in equity markets.
Second, the model assumes that S is a continuous semi-martingale,
and some would argue that stock prices experience jumps.
For certain path-dependent derivatives, we can consider models for
S that allow for the leverage effect (i.e., correlation between W
and ) and permit S to experience jumps.

Time-changed Markov model

We assume the dynamics for S are given by
St = exp (Xt ) ,

Xt = Y t ,

where Y = (Yt )0tT is a Markov process with dynamics given by

Z
e (Yt , dt, dz),
zN
dYt = b(Yt )dt + a(Yt )dWt +
R

e is a state-dependent compensated Poisson random

Here, N
measure
e (y, dt, dz) = N (y, dt, dz) (y, dz)dt.
N

The drift b is chosen so that S is a martingale

Z
1 2
(ez 1 z) (y, dz).
b(Yt ) = a (Yt )
2
R
And = (t )0tT is a continuous stochastic clock which has
arbitrary correlation with S.

The time-change Markov model nests the previous model.

Since is a continuous stochastic clock, it has the representation
Z t
s2 ds,
t =
0

for some non-negative process = (t )0tT .

If 0 and a(y) = 1 then the dynamic of X are given by
dXt = dYt
= 12 dt + dWt

ft ,
= 21 t2 dt + t dW

f.
for some Brownian motion W

In the time-changed Markov model, it is not possible to price an

option with a general European-style payoff of the form:
European-style payoff :

(XT , [X]T ),

where, since X can jump, we use square brackets to denote the

quadratic variation [X]T of the X process.
However, we can price a variance swap (VS)
VS payoff :
relative to co-terminal calls and puts.

[X]T ,

Theorem
Let A denote the generator of the Y process
A = 12 a2 (y)( 2 )
Z


(y, dz) ez 1 (ez 1) ,
+
R

where ez is the shift operator: ez f (y) = f (y + c).

Suppose G is any solution of the integro-differential equation:
Z
2
AG(y) = a (y) +
(y, dz)z 2 .
R

Then, under suitable integrability conditions, the value of the VS is

given by
E [X]T = E G(XT ) G(X0 ).

Proof.
The continuity of the time-change implies [X]T = [Y ]T . Hence
E [X]T = E [Y ]T
Z T Z
Z T
2
z 2 N (Yt , dt, dz)
a (Yt )dt + E
=E
0
R
0

Z T 
Z
=E
z 2 (Yt , dz) dt
a2 (Yt ) +
R
Z 0 T
=E
AG(Yt )dt
Z 0 T
dG(Yt )dt
=E
0

= E G(YT ) G(Y0 )

= E G(XT ) G(X0 ).
The unspecified suitable integrability conditions in the Theorem
are needed to ensure that the local martingale part of dG(Yt ) is a
true martingale.

An explicitly solvable example

We must place some assumptions on a(y) and (y, dz). Suppose
a(y) = 2 (y)02 ,

(y, dz) = 2 (y)0 (dz),

for some function , some constant 0 and some Levy measure 0 .

Then the function G solves
Z
2
0 (dz)z 2 = 21 02 ( 2 )G(y)
0 +
R
Z


0 (dz) ez 1 (ez 1) G(y).
+
R

It is easy to check that G is given by

G(y) = Qy + C,
Thus, the price of a VS is

R
02 + R 0 (dz)z 2
R
Q := 2
.
0 /2 + R 0 (dz)(ez 1 z)

E [X]T = E G(XT ) G(X0 ) = QE (XT X0 ).

Conclusion
We presented three semi-parametric models for a risky asset S; the
second model nests the first.
Under the assumption that S experiences no jumps and volatility is
independent of S (the first model), we have shown how to price
and replicate a variety of path-dependent claims on X and hXi.
When S is allowed to experience jumps and the volatility process
may be correlated with S (the second model), we have shown how
to find the price E [X]T of a VS.
In both models, prices and hedges are directly related to liquid call
and put prices (as opposed to indirectly via a calibration
procedure).

Thank you. Any questions?

Bibliography I

Carr, P. and D. Madan (1998). Towards a theory of volatility

trading. Volatility: new estimation techniques for pricing
derivatives.