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Volatility and Hedging Errors Jim Gatheral September, 25 1999

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Page 1: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Vo

lati

lity

an

d H

edg

ing

Err

ors

Jim

Gat

her

al

Sep

tem

ber

, 25 1

999

Page 2: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Bac

kg

rou

nd

•D

eriv

ativ

e port

foli

o b

ookru

nner

s oft

en c

om

pla

in t

hat

•h

edg

ing

at

mar

ket

-im

pli

ed v

ola

tili

ties

is

sub

-opti

mal

rel

ativ

e to

hed

gin

g a

t th

eir

bes

t gu

ess

of

futu

re v

ola

tili

ty b

ut

•th

ey a

re f

orc

ed i

nto

hed

gin

g a

t m

ark

et i

mp

lied

vola

tili

ties

to

min

imis

e m

ark-t

o-m

ark

et P

&L

vo

lati

lity

.

•A

ll p

ract

itio

ner

s re

cognis

e th

at t

he

assu

mpti

ons

beh

ind

fixed

or

swim

min

g d

elta

choic

es a

re w

rong i

n s

om

e se

nse

.

Nev

erth

eles

s, t

he

mag

nit

ude

of

the

impac

t of

this

del

ta

choic

e m

ay b

e su

rpri

sing.

•G

iven

the

P&

L i

mpac

t of

thes

e ch

oic

es, it

would

be

nic

e to

be

able

to a

void

fig

uri

ng o

ut

how

to d

elta

hed

ge.

Is

ther

e a

way

of

avoid

ing t

he

pro

ble

m?

Page 3: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

An

Idea

lise

dM

od

el

•T

o g

et i

ntu

itio

n a

bout

hed

gin

g o

pti

ons

at t

he

wro

ng

vola

tili

ty, w

e co

nsi

der

tw

o p

arti

cula

r sa

mple

pat

hs

for

the

stock

pri

ce, both

of

whic

h h

ave

real

ised

vola

tili

ty =

20%

•a

whip

saw

pat

h w

her

e th

e st

ock

pri

ce m

oves

up a

nd

dow

n b

y 1

.25%

ever

y d

ay

•a

sine

curv

e des

igned

to m

imic

a t

rendin

g m

arket

Page 4: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Wh

ipsa

w a

nd

Sin

e C

urv

e S

cen

ario

s

2 P

ath

s w

ith

Vo

lati

lity

=2

0%

0

0.51

1.52

2.53

3.54

4.5

0

16

32

48

64

80

96

112

128

144

160

176

192

208

224

240

256

Day

s

Spot

Page 5: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Wh

ipsa

wv

sS

ine

Cu

rve:

Res

ult

s

P&

Lvs

He

dg

eV

ol.

(80,0

00,0

00

)

(60,0

00,0

00

)

(40,0

00,0

00

)

(20,0

00,0

00

)

-

20,0

00,0

00

40,0

00,0

00

60,0

00,0

00

10%

15%

20%

25%

30%

35%

40%Hed

ge

Vola

tili

ty

P&L

Whip

saw

Sin

e W

ave

Page 6: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Co

ncl

usi

on

s fr

om

th

is E

xp

erim

ent

•If

you k

new

the

real

ised

vola

tili

ty i

n a

dvan

ce, you w

ould

def

init

ely h

edge

at t

hat

vola

tili

ty b

ecau

se t

he

hed

gin

g e

rror

at t

hat

vola

tili

ty w

ould

be

zero

.

•In

pra

ctic

e of

cours

e, y

ou d

on’t

know

what

the

real

ised

vola

tili

ty w

ill

be.

T

he

per

form

ance

of

your

hed

ge

dep

ends

not

only

on w

het

her

the

real

ised

vola

tili

ty i

s hig

her

or

low

er t

han

your

esti

mat

e but

also

on w

het

her

the

mar

ket

is

range

bound o

r tr

endin

g.

Page 7: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

An

aly

sis

of

the

P&

L G

rap

h

•If

the

mar

ket

is

range

bound, hed

gin

g a

short

opti

on

posi

tion a

t a

low

ervol.

hurt

s bec

ause

you a

re g

etti

ng

conti

nuousl

y w

hip

saw

ed. O

n t

he

oth

er h

and, if

you

hed

ge

at v

ery h

igh

vol.

, an

d m

arket

is

range

bound,

your

gam

ma

is v

ery l

ow

and y

our

hed

gin

g l

oss

es a

re

min

imis

ed.

•If

the

mar

ket

is

tren

din

g, you a

re h

urt

if

you h

edge

at a

hig

her

vol.

bec

ause

your

hed

ge

reac

ts t

oo s

low

ly t

o t

he

tren

d. I

f you h

edge

at l

ow

vol.

, t

he

hed

ge

rati

o g

ets

hig

her

fas

ter

as y

ou g

o i

n t

he

money

min

imis

ing

hed

gin

g l

oss

es.

Page 8: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

An

oth

er S

imp

le H

edg

ing

Ex

per

imen

t•

In o

rder

to s

tudy t

he

effe

ct o

f ch

angin

g h

edge

vola

tili

ty, w

e

consi

der

the

foll

ow

ing s

imple

port

foli

o:

•sh

ort

$1bn n

oti

onal

of

1 y

ear

AT

M E

uro

pea

n c

alls

•lo

ng a

one

yea

r vola

tili

ty s

wap

to c

ance

l th

e veg

a of

the

call

s at

ince

pti

on.

•T

his

is

(alm

ost

) eq

uiv

alen

t to

hav

ing s

old

a o

ne

yea

r opti

on

whose

pri

ce i

s det

erm

ined

ex-p

ost

bas

ed o

n t

he

actu

al

vola

tili

ty r

eali

sed o

ver

the

hed

gin

g p

erio

d.

•A

ny P

&L

gen

erat

ed b

y t

his

hed

gin

g s

trat

egy i

s pure

hed

gin

g e

rror.

T

hat

is,

we

elim

inat

e an

y P

&L

due

to

vola

tili

ty m

ovem

ents

.

Page 9: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

His

tori

cal

Sam

ple

Pat

hs

•In

ord

er t

o p

reem

pt

crit

icis

m t

hat

our

sam

ple

pat

hs

are

too

unre

alis

tic,

we

take

real

his

tori

cal

FT

SE

dat

a fr

om

tw

o

dis

tinct

his

tori

cal

per

iods:

one

wher

e th

e m

arket

was

lock

ed i

n a

tre

nd a

nd o

ne

wher

e th

e m

arket

was

ran

ge

bound.

•F

or

the

ran

ge

bo

und

sce

nar

io, w

e co

nsi

der

the

per

iod f

rom

Apri

l

1991

to

Apri

l 19

92

•F

or

the

tren

din

g s

cen

ario

, w

e co

nsi

der

th

e p

erio

d f

rom

Oct

ob

er

1996

to

Oct

ober

19

97

•In

bo

th s

cenar

ios,

th

ere

alis

edvo

lati

lity

was

aro

und

12%

Page 10: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

FT

SE

10

0 s

ince

19

85

0

1000

2000

3000

4000

5000

6000

7000 1

/1/8

55/2

2/8

610/1

0/8

72/2

7/8

97/1

8/9

012/6

/91

4/2

5/9

39/1

3/9

42/1

/96

6/2

1/9

711/9

/98

Ran

ge

Tre

nd

Page 11: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ran

ge

Sce

nar

ioF

TS

E f

rom

4/1

/91 t

o 3

/31/9

2

200

0

210

0

220

0

230

0

240

0

250

0

260

0

270

0

280

0

290

0

300

0 3/3

/91

4/2

2/9

16/1

1/9

17/3

1/9

19/1

9/9

111/8

/91

12/2

8/9

12/1

6/9

24/6

/92

5/2

6/9

2

Rea

lise

d V

ola

tili

ty 1

2.1

7%

Page 12: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Tre

nd S

cenar

ioF

TS

E f

rom

11/1

/96 t

o 1

0/3

1/9

7

3500

3700

3900

4100

4300

4500

4700

4900

5100

5300

5500 8/2

3/9

610/1

2/9

612/1

/96

1/2

0/9

73/1

1/9

74/3

0/9

76/1

9/9

78/8

/97

9/2

7/9

711/1

6/9

7

Rea

lise

d V

ola

tili

ty 1

2.4

5%

Page 13: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

P&

Lvs

Hed

ge

Vola

tili

ty

(25,0

00,0

00)

(20,0

00,0

00)

(15,0

00,0

00)

(10,0

00,0

00)

(5,0

00,0

00)

-

5,0

00,0

00

10,0

00,0

00

15,0

00,0

00

20,0

00,0

00

25,0

00,0

00

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

Ran

ge

Sce

nar

io

Tre

nd S

cenar

io

Page 14: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Dis

cuss

ion

of

P&

L S

ensi

tivit

ies

•T

he

sensi

tivit

y o

f th

e P

&L

to h

edge

vola

tili

ty d

id d

epen

d

on t

he

scen

ario

just

as

we

would

hav

e ex

pec

ted f

rom

the

idea

lise

d e

xper

imen

t.

•In

th

e ra

ng

e sc

enar

io,

the

low

er t

he

hed

ge

vola

tili

ty, th

e lo

wer

the

P&

L c

on

sist

ent

wit

h t

he

wh

ipsa

w c

ase.

•In

th

e tr

end s

cen

ario

, th

e lo

wer

th

e h

edg

e vo

lati

lity

, th

e h

igher

th

e

P&

L c

on

sist

ent

wit

h t

he

sine

curv

e ca

se.

•In

eac

h s

cenar

io, th

e se

nsi

tivit

y o

f th

e P

&L

to h

edgin

g a

t a

vola

tili

ty w

hic

h w

as w

rong b

y 1

0 v

ola

tili

ty p

oin

ts w

as

around $

20m

m f

or

a $1bn p

osi

tion.

Page 15: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Qu

esti

on

s?

•S

uppose

you s

ell

an o

pti

on a

t a

vola

tili

ty h

igher

than

12%

and h

edge

at s

om

e oth

er v

ola

tili

ty. I

f re

alis

ed v

ola

tili

ty i

s

12%

, do y

ou m

ake

money

?

•N

ot

nec

essa

rily

. I

t is

eas

y t

o f

ind s

cen

ario

s w

her

e you

lose

mo

ney

.

•S

uppose

you s

ell

an o

pti

on a

t so

me

impli

ed v

ola

tili

ty a

nd

hed

ge

at t

he

sam

e vola

tili

ty. I

f re

alis

ed v

ola

tili

ty i

s 12%

,

when

do y

ou m

ake

mon

ey?

•In

th

e tw

o s

cenar

ios

anal

yse

d, if

the

op

tion

is

sold

and

hed

ged

at

a

vola

tili

ty g

reat

er t

han

th

e re

alis

ed v

ola

tili

ty, th

e tr

ade

mak

es

mo

ney

. T

his

co

nfo

rms

to t

rad

ers’

intu

itio

n.

•L

ater

, w

e w

ill

sho

w t

hat

ev

en t

his

is

not

alw

ays

tru

e.

Page 16: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Sal

e/ H

edg

e V

ola

tili

ty C

om

bin

atio

ns

Sale

Vol.

Vola

tili

ty

P&

L

Hed

ge

Vol.

Hed

ge

P&

L

Tota

l

Ran

ge

Sce

nar

io13%

+$3.3

0m

m10%

-$3.8

5m

m-$

0.5

5m

m

Tre

nd

Sce

nar

io13%

+$2.2

0m

m17%

-$3.0

7m

m-$

0.8

7m

m

Page 17: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

P&

L f

rom

Sel

lin

g a

nd

Hed

gin

g a

t

the

Sam

e V

ola

tili

ty

(60,0

00,0

00)

(40,0

00,0

00)

(20,0

00,0

00)

-

20,0

00,0

00

40,0

00,0

00

60,0

00,0

00

80,0

00,0

00

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

Ran

ge

Sce

nar

io

Tre

nd S

cenar

io

Page 18: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Del

ta S

ensi

tivit

ies

•L

et’s

now

see

what

eff

ect

hed

gin

g a

t th

e w

rong v

ola

tili

ty

has

on t

he

del

ta.

•W

e lo

ok a

t th

e d

iffe

ren

ce b

etw

een

$-d

elta

co

mp

ute

d a

t 20%

vola

tili

ty a

nd

$-d

elta

co

mp

ute

d a

t 12

% v

ola

tili

ty a

s a

fun

ctio

n o

f

tim

e.

•In

the

range

scen

ario

, th

e dif

fere

nce

bet

wee

n t

he

del

tas

per

sist

s th

roughout

the

hed

gin

g p

erio

d b

ecau

se b

oth

gam

ma

and

veg

are

mai

n s

ignif

ican

t th

roughout.

•O

n t

he

oth

er h

and, in

the

tren

d s

cenar

io, as

gam

ma

and

veg

adec

reas

e, t

he

dif

fere

nce

bet

wee

n t

he

del

tas

also

dec

reas

es.

Page 19: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ran

ge

Sce

nar

io

$ D

elta D

iffere

nce (

20%

vol. -

12%

vol.)

(150,0

00,0

00)

(100,0

00,0

00)

(50,0

00,0

00)

-

50,0

00,0

00

100,0

00,0

00

150,0

00,0

00

050

100

150

200

250

300

Page 20: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Tre

nd

Sce

nar

io

$ D

elta D

iffere

nce (

20%

vol. -

12%

vol.)

(120,0

00,0

00)

(100,0

00,0

00)

(80,0

00,0

00)

(60,0

00,0

00)

(40,0

00,0

00)

(20,0

00,0

00)

-

20,0

00,0

00

40,0

00,0

00

60,0

00,0

00

050

100

150

200

250

300

Page 21: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Fix

ed a

nd

Sw

imm

ing

Del

ta

•F

ixed

(st

icky s

trik

e) d

elta

ass

um

es t

hat

the

Bla

ck-S

chole

s

impli

ed v

ola

tili

ty f

or

a par

ticu

lar

stri

ke

and e

xpir

atio

n i

s

const

ant.

T

hen

•S

wim

min

g (

or

float

ing)

del

ta a

ssum

es t

hat

the

at-t

he-

money

Bla

ck-S

chole

s im

pli

ed v

ola

tili

ty i

s co

nst

ant.

M

ore

pre

cise

ly, w

e as

sum

e th

at i

mpli

ed v

ola

tili

ty i

s a

funct

ion o

f

rela

tive

stri

ke

o

nly

. T

henS

CB

SF

IXE

D∂∂

K

C

SK

S

C

S

C

S

CB

S

BS

BS

BS

BS

BS

BS

BS

SW

IM∂∂

∂∂−

∂∂=

∂∂

∂∂+

∂∂=

σ

σ

σ

σδ

SK

Page 22: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

An

Asi

de:

Th

e V

ola

tili

ty S

kew

SP

X V

ola

tility

6-A

pr-

99

10.0

0%

20.0

0%

30.0

0%

40.0

0%

50.0

0%

60.0

0%

70.0

0%

80.0

0%

90.0

0%

500

700

900

1100

1300

1500

1700

4/1

5/9

9

5/2

0/9

9

6/1

7/9

9

9/1

6/9

9

12/1

6/9

9

3/1

6/0

0

6/1

5/0

0

12/1

4/0

0

Str

ike

Vola

tili

ty

Page 23: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Vo

lati

lity

vs

x

0.0

0%

10.0

0%

20.0

0%

30.0

0%

40.0

0%

50.0

0%

60.0

0%

70.0

0%

80.0

0%

90.0

0%

-3-2

.5-2

-1.5

-1-0

.50

0.5

11.5

4/1

5/9

9

5/2

0/9

9

6/1

7/9

9

9/1

6/9

9

12/1

6/9

9

3/1

6/0

0

6/1

5/0

0

12/1

4/0

0

()

TF

Kx

ln=

Page 24: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ob

serv

atio

ns

on

th

e V

ola

tili

ty S

kew

•N

ote

how

bea

uti

ful

the

raw

dat

a lo

oks;

ther

e is

a v

ery w

ell-

def

ined

pat

tern

of

impli

ed v

ola

tili

ties

.

•W

hen

im

pli

ed v

ola

tili

ty i

s plo

tted

agai

nst

, a

ll o

f

the

skew

curv

es h

ave

roughly

the

sam

e sh

ape.

T

FK

)/

ln(

Page 25: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ho

w B

ig a

re t

he

Del

ta D

iffe

ren

ces?

•W

e as

sum

e a

skew

of

the

form

•F

rom

the

foll

ow

ing t

wo g

raphs,

we

see

that

the

typic

al

dif

fere

nce

in d

elta

bet

wee

n f

ixed

and s

wim

min

g

assu

mpti

ons

is a

round $

100m

m. T

he

erro

r in

hed

ge

vola

tili

ty w

ould

nee

d t

o b

e ar

ound 8

poin

ts t

o g

ive

rise

to a

sim

ilar

dif

fere

nce

.

•In

the

range

scen

ario

, th

e dif

fere

nce

bet

wee

n t

he

del

tas

per

sist

s th

roughout

the

hed

gin

g p

erio

d b

ecau

se b

oth

gam

ma

and v

ega

rem

ain s

ignif

ican

t th

roughout.

•O

n t

he

oth

er h

and, in

the

tren

d s

cenar

io, as

gam

ma

and

veg

a dec

reas

e, t

he

dif

fere

nce

bet

wee

n t

he

del

tas

also

dec

reas

es.

TxB

S3.

0−

=∂

∂σ

Page 26: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ran

ge

Sce

nar

io

Sw

imm

ing

De

lta

-Fix

ed

De

lta

(20,0

00,0

00)

-

20,0

00,0

00

40,0

00,0

00

60,0

00,0

00

80,0

00,0

00

100,0

00,0

00

120,0

00,0

00

140,0

00,0

00

050

100

150

200

250

300

Page 27: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Tre

nd

Sce

nar

io

Sw

imm

ing

De

lta

-Fix

ed

De

lta

(20,0

00,0

00)

-

20,0

00,0

00

40,0

00,0

00

60,0

00,0

00

80,0

00,0

00

100,0

00,0

00

120,0

00,0

00

140,0

00,0

00

050

100

150

200

250

300

Page 28: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Su

mm

ary

of

Em

pir

ical

Res

ult

s•

Del

ta h

edgin

g a

lway

s giv

es r

ise

to h

edgin

g e

rrors

bec

ause

we

cannot

pre

dic

tre

alis

edvola

tili

ty.

•T

he

resu

lt o

f hed

gin

g a

t to

o h

igh o

r to

o l

ow

a v

ola

tili

ty

dep

ends

on t

he

pre

cise

pat

h f

oll

ow

ed b

y t

he

under

lyin

g

pri

ce.

•T

he

effe

ct o

f hed

gin

g a

t th

e w

rong v

ola

tili

ty i

s of

the

sam

e ord

er o

f m

agnit

ude

as t

he

effe

ct o

f hed

gin

g u

sing

swim

min

g r

ather

than

fix

ed d

elta

.

•F

iguri

ng o

ut

whic

h d

elta

to u

se a

t le

ast

as i

mport

ant

than

gues

sing f

utu

re v

ola

tili

ty c

orr

ectl

y a

nd

pro

bab

ly m

ore

im

port

ant!

Page 29: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

So

me

Th

eory

•C

onsi

der

a E

uro

pea

n c

all

opti

on s

truck

at

K e

xpir

ing a

t

tim

e T

and d

enote

the

val

ue

of

this

opti

on a

t ti

me

t

acco

rdin

g t

o t

he

Bla

ck-S

chole

s fo

rmula

by

. I

n

par

ticu

lar,

.

•W

e as

sum

e th

at t

he

stock

pri

ce S

sat

isfi

es a

SD

E o

f th

e

form

wher

e m

ay i

tsel

f be

stoch

asti

c.

•P

ath-b

y-p

ath, w

e hav

e

Ct

BSb g

CT

SK

BS

Tbgbg

=−

+

dS S

dt

dZ

t t

tt

St

=+

µσ

,

σt

St

,

Page 30: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

CT

CdC

C Sd

SC

td

tS

C Sdt

C Sd

SS

C Sd

t

BS

BS

BS

T

BS t

tB

SS

tB

S

t

T

BS t

tS

tt

BS

t

T

t

t

bgb g

−= =

∂ ∂+

∂+

∂ ∂

R S| T|U V| W|

=∂ ∂

+−

∂ ∂

R S TU V W

z z z

0

2

0

22

2

20

1 2

22

22

20

σ

σσ

)

wher

e th

e fo

rwar

d v

aria

nce

.

So, if

we

del

ta h

edge

usi

ng t

he

Bla

ck-S

chole

s (f

ixed

) del

ta,

the

outc

om

e of

the

hed

gin

g p

roce

ss i

s:

ɵ.

σσ

tB

St

tt

22

=∂ ∂b g

ns

CT

CS

C Sdt

BS

BS

St

tB

S

t

T

tbgb g

−=

−∂ ∂

z0

1 2

22

22

20

σ

Page 31: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

•In

the

Bla

ck-S

chole

s li

mit

, w

ith d

eter

min

isti

c vola

tili

ty,

del

ta-h

edgin

g w

ork

s pat

h-b

y-p

ath b

ecau

se

•In

rea

lity

, w

e se

e th

at t

he

outc

om

e dep

ends

both

on g

amm

a

and t

he

dif

fere

nce

bet

wee

nre

alis

edan

d h

edge

vola

tili

ties

.

•If

gam

ma

is h

igh w

hen

vo

lati

lity

is

low

and

/or

gam

ma

is l

ow

wh

en

vola

tili

ty i

s h

igh

you

wil

l m

ake

mo

ney

and

vic

e ve

rsa

.

•N

ow

, w

e ar

e in

a p

osi

tion t

o p

rovid

e a

counte

rexam

ple

to

trad

er i

ntu

itio

n:

•C

on

sid

er t

he

par

ticu

lar

pat

h s

how

n i

n t

he

foll

ow

ing

sli

de:

•T

he

real

ised

vo

lati

lity

is

12

.45

% b

ut

vo

lati

lity

is

clo

se t

o z

ero

wh

en g

amm

a is

lo

w a

nd h

igh

wh

en g

amm

a is

hig

h.

•T

he

hig

her

th

e h

edg

e vo

lati

lity

, th

e lo

wer

the

hed

ge

P&

L.

•In

th

is c

ase,

if

yo

u p

rice

and

hed

ge

a s

hort

opti

on

po

siti

on a

ta

vola

tili

ty l

ow

er t

han

18

%, you l

ose

mo

ney

.

σσ

St

tt

S2

2=

∀ɵ

Page 32: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

A C

oo

ked

Sce

nar

io

3500

4000

4500

5000

5500

6000

050

100

150

200

250

Page 33: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Co

ok

ed S

cen

ario

: P

&L

fro

m S

elli

ng

and

Hed

gin

g a

t th

e S

ame

Vo

lati

lity

(15,0

00,0

00)

(10,0

00,0

00)

(5,0

00,0

00)

-

5,0

00,0

00

10,0

00,0

00

15,0

00,0

00

20,0

00,0

00

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

Page 34: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Co

ncl

usi

on

s

•D

elta

-hed

gin

g i

s so

unce

rtai

n t

hat

we

must

del

ta-h

edge

as

litt

le a

s poss

ible

and w

hat

del

ta-h

edgin

g w

e do m

ust

be

opti

mis

ed.

•T

o m

inim

ise

the

nee

d t

o d

elta

-hed

ge,

we

must

fin

d a

sta

tic

hed

ge

that

min

imis

esgam

ma

pat

h-b

y-p

ath. F

or

exam

ple

,

Avel

laned

aet

al.

hav

e der

ived

such

sta

tic

hed

ges

by

pen

alis

ing g

amm

a pat

h-b

y-p

ath.

•T

he

ques

tion o

f w

hat

del

ta i

s opti

mal

to u

se i

s st

ill

open

.

Tra

der

s li

ke

fixed

and s

wim

min

g d

elta

. Q

uan

ts p

refe

r

mar

ket

-im

pli

ed d

elta

-th

e del

ta o

bta

ined

by a

ssum

ing t

hat

the

loca

l vola

tili

ty s

urf

ace

is f

ixed

.

Page 35: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

An

oth

er D

igre

ssio

n:

Lo

cal

Vo

lati

lity

•W

e as

sum

e a

pro

cess

of

the

form

:

wit

h a

det

erm

inis

tic

funct

ion o

f st

ock

pri

ce a

nd t

ime.

•L

oca

l vola

tili

ties

can b

e co

mpute

d f

rom

mar

ket

pri

ces

of

opti

ons

u

sing

•M

arket

-im

pli

ed d

elta

ass

um

es t

hat

the

loca

l vola

tili

ty

surf

ace

stay

s fi

xed

thro

ugh t

ime.

dS S

dt

dZ

t t

tt

St

=+

µσɵ

,

ɵ,

σt

St

2

2

,2 2

ˆ

KCTC

KT

∂∂∂∂

=σK

T,

σ̂ C

Page 36: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

CT

CdC

C SdS

C td

tS

C Sdt

C SdS

SC S

dt

LL

L

T

L t

tL

tS

tL

t

T

L t

tt

St

St

L

t

T

t

tt

bgb g

−= =

∂ ∂+

∂ ∂+

∂ ∂

R S| T|U V| W|

=∂ ∂

+−

∂ ∂

R S TU V W

z z z

0

2

0

22

2

20

1 2

22

22

20

σ

σσ

,

,,

)

We

can e

xte

nd t

he

pre

vio

us

anal

ysi

s to

loca

l vola

tili

ty.

So, if

we

del

ta h

edge

usi

ng t

he

mar

ket

-im

pli

ed d

elta

,th

e

outc

om

e of

the

hed

gin

g p

roce

ss i

s:

CT

CS

C Sdt

LL

tS

tS

tL

t

T

tt

bgb g

−=

−∂ ∂

z0

1 2

22

22

20

),

σ

∂ ∂C S

L t

Page 37: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

ΓL

tt

L

t

SS

C Sbg≡

∂ ∂

22

2D

efin

e

Then

If t

he

clai

m b

eing h

edged

is

pat

h-d

epen

den

t th

en i

s al

so

pat

h-d

epen

den

t. O

ther

wis

e al

l th

e ca

n b

e det

erm

ined

at

ince

pti

on.

Wri

ting t

he

last

equat

ion o

ut

in f

ull

, fo

r tw

o l

oca

l vola

tili

ty

surf

aces

w

e get

Then

, th

e fu

nct

ional

der

ivat

ive

CT

CS

dt

LL

tS

tS

Lt

T

tt

bgb g

bg

−=

−z

01 2

22

0(

ɵ)

,,

σσ

Γ

ΓL

tS bg

ΓL

tS bg

CC

dt

dS

ES

SS

Sdt

LL

tt

St

SL

tt

t

T

tt

(~ɵ

),

ΣΓ

didi

bgch

−=

−∞ zz

1 2

22

00

σϕ

ΣΣ

ˆ an

d

~

δ δσϕ

CE

SS

SS

L

tS

Lt

tt

t

ɵ,

21 2

0=

Γbgch

Page 38: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

In p

ract

ice,

we

can s

et by b

uck

et h

edgin

g.

Note

in p

arti

cula

r th

at E

uro

pea

n o

pti

ons

hav

e al

l th

eir

sensi

tivit

y

to l

oca

l vola

tili

ty i

n o

ne

buck

et -

at s

trik

e an

d e

xpir

atio

n. T

hen

by b

uyin

g a

nd s

elli

ng E

uro

pea

n o

pti

ons,

we

can c

ance

l th

e ri

sk-

neu

tral

expec

tati

on o

f gam

ma

over

the

life

of

the

opti

on b

eing

hed

ged

-a

stat

ic h

edge.

This

is

not

the

sam

e as

can

cell

ing g

amm

a

pat

h-b

y-p

ath.

If y

ou d

o t

his

, you s

till

nee

d t

o c

hoose

a d

elta

to h

edge

the

rem

ainin

g r

isk. I

n p

ract

ice,

whet

her

fix

ed, sw

imm

ing o

r m

arket

-

impli

ed d

elta

is

chose

n, th

e par

amet

ers

use

d t

o c

om

pute

thes

e ar

e

re-e

stim

ated

dai

ly f

rom

a n

ew i

mpli

ed v

ola

tili

ty s

urf

ace.

Du

mas

, F

lem

ing a

nd W

hal

ey p

oin

t out

that

the

loca

l vola

tili

ty

surf

ace

is v

ery u

nst

able

over

tim

e so

agai

n, it

’s n

ot

obvio

us

whic

h d

elta

is

opti

mal

.

δ δσ

CL

tS

t,

20

=

Page 39: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

Ou

tsta

nd

ing

Res

earc

h Q

ues

tio

ns

•Is

ther

e an

opti

mal

choic

e of

del

ta w

hic

h d

epen

ds

only

on

obse

rvab

le a

sset

pri

ces?

•H

ow

should

we

pri

ce

•P

ath-d

epen

den

t op

tion

s?

•F

orw

ard s

tart

ing

opti

on

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on

s?

•V

ola

tili

ty s

wap

s?

Page 40: Volatility and Hedging Errors - Baruch Collegefaculty.baruch.cuny.edu/jgatheral/hedgevolcolumbia0999.pdf · An Idealised Model • To get intuition about hedging options at the wron

So

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