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1. Introduction volatility surface and analyse a few examples. We will develop further the
copula implied basket volatility construction technique (ref. 5) and exam-
Equity basket options have long been important tools in structuring ine the relationship between the basket skew and correlation skew. The
financial products. They are widely used in portfolio management and as effect of the correlation skew and its structural change on the basket
retail products as they are typically more cost-effective than multiple sin- skew will also be examined.
gle underlying options. The components in a basket can be single stocks
(names), equity indices or funds. Historically, managing basket option
books has proved to be problematic and rather difficult for many banks. 2. Basket Risks
Quite often, when the markets move, the basket options and their A typical basket consists of several underlyings with associated weight-
hedges, which are supposed to offset the basket positions, do not move in ings. The basket spot is:
the directions as they are supposed to. In these circumstances the basket
n
pricing models used are partially responsible as they fail to capture cer- SB = w i · Si
tain type of fundamental basket risks. Among them, the correlation i=1
skew and its structural change triggered by sudden market move are the
Where wi is the weightings and Si the individual underlyings. The values
key contributors.
of European call and put options on the basket are calculated from:
In the absence of a volatility smile/skew, a European option on a bas-
ket can be priced using various techniques (ref. 1–4), including moment EQ Max(SB − K, 0) ; Call
matching or geometric conditioning. In the presence of a volatility EQ Max(K − SB , 0) ; Put
smile/skew, pricing basket options becomes much more complicated. It
becomes important to understand how the basket skew behaves and how A basket option book will generally consist of numerous basket calls
the skewed correlation structure is related to it. and puts, as defined above. In addition to the normal first order risks
Interestingly, although the correlation skew has long been a topic of (e.g. delta, gamma, vega) associated with individual basket underlying,
study in the context of equity derivatives basket, and the copula tech- there are several other key basket specific risk exposures. A summary of
nique was one of the proposed methods (ref. 5) to deal with it, it is in the the basket specific risks is given in the table below.
credit derivatives business, the copula technique becomes an industry It is evident that a basket (correlation) book is a complex entity
standard to deal with basket of names. In this paper, we will still focus on involving significant second order effects that needs to be understood
equity derivatives basket. The key risks associated with the basket options and modelled. In the following, we will analyse the basket volatility skew
will be investigated. We will review a technique to extract historic basket risks and the associated correlation issues.
58 Wilmott magazine
TECHNICAL ARTICLE 2
Wilmott magazine 59
1.5%
50%
1.0%
40%
0.5% 30%
20%
0.0%
70% 90% 110% 130% 150% 10%
50%
2.0
80%
Where DF is the discount factor. The option prices can then be used to
110%
140%
recover the implied volatility points at Ki . By repeating the above steps at 0.08
170%
200%
different time interval T , one can build an historic volatility surface for the
basket. In the following, we examine a few examples of the historic volatil-
ity surfaces. Fig. 3 shows a historic volatility surface for FTSE-100. The short
Figure 4: FT-Banks Historic Vol Surface.
end skew is quite strong as expected. The historic volatility surface shown
in Fig. 4 is that of the FTSE-100 banking sector basket. Clearly there is a
smile at the short end and skew at the longer end. In Fig. 5, the historic
volatility surface for an equally weighted index basket of FTSE-100, S&P and
EUROSTOCK 50 is shown. Again the smile/skew is apparent in the figure. 25%
While the historic basket volatility surfaces provide valuable smile/skew
information of the basket, it is relatively static. When the market moves, the 20%
historic information changes little given that the recent contribution con-
stitutes a relatively small proportion of the time series. For day-to-day trad- 15%
ing and hedging purposes, one requires different approaches to cater for
rapidly changing market conditions and the basket volatility surfaces 10%
should incorporate the latest market information.
5%
3.0
50% 0% 0.75
70%
90%
0.08
40% 110%
130%
30%
Figure 5: Index Basket Historic Vol Surface.
20%
80%
110%
0.08
170%
60 Wilmott magazine
TECHNICAL ARTICLE 2
Wilmott magazine 61
50% 75%
40%
50%
30%
20%
25%
10%
7.0 7.0
0%
y
0% 2.0
pir
2.0
y
pir
50%
Ex
70%
50%
90%
Ex
70%
110%
90%
0.1
130%
110%
0.1
150%
130%
170%
150%
190%
170%
190%
Strike
Strike
Figure 7: Implied Vol Surface (Underlying 1). Figure 9: Implied Vol Surface (Underlying 3).
60% 40%
30%
40%
20%
20%
10%
7.0
0% 7.0
0% 2.0
y
50%
pir
50%
70%
2.0
80%
90%
Ex
ry
110%
110%
130%
pi
0.1
150%
Ex
170%
140%
190%
0.1
170%
200%
Strike Strike
62 Wilmott magazine
TECHNICAL ARTICLE 2
55% −40%
Cor = −20% Underlying 1
Cor = 0% Underlying 2
Cor = 50%
45% −30% Basket (Cor = 0%)
Cor = 90%
Basket (Cor = 80%)
35% −20%
25% −10%
15% 0%
60% 80% 100% 120% 140% 0 1 2 3 4 5 6 7
Strike
Figure 13: Skew Term Structure.
Figure 11: Basket Implied Volatility (1Y).
Wilmott magazine 63
TECHNICAL ARTICLE 2
7500 Both volatility and skew are positive functions of the corre-
FTSE
lation. Skewed correlation structures can be imposed onto the
basket during the construction process. The correlation struc-
ESTX
ture impacts the basket skew and basket option prices. A real-
S&P istic and consistent basket skew framework built by incorpo-
5000 rating a skewed correlation structure should be able to cap-
ture some risk exposures of dramatic market falls.
It is possible to extend the basket volatility surface con-
struction technique to other multi-asset basket structures. For
example, in the following multi-asset option structures:
2500
Call On Worst Of : max(min(S1 , S2 , · · · , Sn ) − K, 0)
Put On Worst Of : max(K − min(S1 , S2 , · · · , Sn ), 0)
Call On Best Of : max(max(S1 , S2 , · · · , , Sn ) − K, 0)
0 Put On Best Of : max(K − max(S1 , S2 , · · · , Sn ), 0)
0 530 1060 1590 2120 2650
the worst-of Smin = min(S1 , S2 , · · · , Sn ) and the best of
Figure 14: Historic Spot (FTSE, ESTX, S&P). Smax = max(S1 , S2, · · · , Sn ) can be treated as the new single
underlying similar to the basket underlying SB . The new sin-
gle underlying’s terminal spots can be simulated using the copula tech-
2.0%
nique which links the individual CDFs with an appropriate dependence
Flat Cor (44%)
(correlation) structure. The simulated spots can then be used to calculate
Skewed Cor (Local Vol)
the option prices at different strikes. The implied volatility surfaces for
1.0% Skewed Cor (Large Step)
the new single underlying can be backed out from option prices, and the
skew risk measurements of these multi-asset option structures can be
conducted similarly.
0.0% Finally, although this paper deals with the copula and correlation
80% 90% 100% 110% 120% skew in the context of equity basket option, the techniques and the
thought process can potentially benefit credit derivatives professionals
too. It will be very interesting to see cross fertilization between equity
−1.0%
and credit derivatives professionals.
−2.0%
Strike
5. Conclusions REFERENCES
A basket volatility surface construction technique is developed using the ■ D. Gentle, “Basket Weaving”, Risk, Vol. 6, No. 6, p. 51 (1993)
copula methodology. It captures the information in the implied volatili- ■ M. A. Milevsky and S. E. Posner, “A Closed-Form Approximation for Valuing Basket
ty surfaces of the individual basket components. The copula basket Options”, The Journal of Derivatives, Summer 1998, p. 54
volatility surface construction technique is computational efficient as it ■ C. B. Huynh, “Back to Baskets”, Risk, Vol. 7, No. 5, p. 59 (1994)
■ M. Curran, “Valuing Asian and Portfolio Options by Conditioning on the Geometric
is in large steps at finite time slices. Once the basket volatility surface is
Mean Price”, Management Science (1994), No. 12, p. 1705–1711.
built, the basket can be treated as a new single underlying and the sur-
■ D. Qu, “Basket Implied Volatility Surface”, Derivatives Week, 4 June 2001.
faces could be interpolated or extrapolated for pricing and risk manag- ■ J. Zou and E. Derman, “Strike-Adjusted Spread: A New Metric For Estimating The
ing basket products in a consistent manner. The risk parameters relevant Value Of Equity Options”, Goldman Sachs Quantitative Strategies Research Notes,
W to individual volatility skew as well as the correlation effects can be gen- July 1999.
erated within the same framework.
64 Wilmott magazine