Stochastic Volatility

A Gentle Introduction

Fredrik Armerin
Department of Mathematics
Royal Institute of Technology, Stockholm, Sweden

Contents
1 Introduction
1.1 Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2 Assumptions and notation . . . . . . . . . . . . . . . . . . . . . .

2
2
5

2 The Black & Scholes model

2.1 Valuation of contingent claims . . . . . . . . . . . . . . . . . . . .
2.2 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . .

6
6
7

3 Extending the Black & Scholes model

3.1 Time dependent volatility . . . . . . . . . . .
3.1.1 Getting (t) from the implied volatility
3.1.2 Conclusions . . . . . . . . . . . . . . .
3.2 Time- and state dependent volatility . . . . .

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12
12

4 Models with stochastic volatility

4.1 The market model . . . . . . . .
4.2 Pricing . . . . . . . . . . . . . . .
4.3 Choosing the martingale measure
4.4 Uncorrelated processes . . . . . .
4.5 Correlated processes . . . . . . .
4.6 The leverage effect . . . . . . . .

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17
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5 Hedging and stochastic volatility

5.1 The cost process . . . . . . . . . . . .
5.2 Hedging a call option . . . . . . . . . .
5.3 Hedging general contingent claims . . .
5.4 The Black-Scholes-Barenblatt equation

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Chapter 1
Introduction
1.1

Volatility

The purpose with these notes is to give an introduction to the important topic of
stochastic volatility. Volatility is the standard deviation of the return of an asset.
In the model used by Black & Scholes the stock price ST at time T is assumed
to fulfill
2
ST = St e( /2)(T t)+(WT Wt ) ,
where and > 0 are constants and W is a standard Brownian motion (or
Wiener process). The return between time t and t + can thus be written

St+
2
ln
=
+ (Wt+ Wt ).
St
2
From this we see two assumptions included in the Black & Scholes model:
The returns are normally distributed, and
the standard deviation of the returns (i.e. the volatility) is constant.
If one looks at time series of stock returns, it is quite easy to see that both these
assumptions are not consistent with the data.1
Example 1.1.1 We have a time series with 267 observations of the daily return
of the IBM share. The price and the return series are plotted in Figure 1.1.
Looking at them doesnt say much. Let us now look at the 30-day volatility. By
this we mean the historical volatility we get if we use the 30 latest observations.
It is then scaled to give the yearly volatility. From this picture it looks like the
volatility changes over time. We have also plotted a histogram of the return; see
Figure 1.2. We have estimated the daily mean
b and standard deviation
b of the
1

It is possible to use econometric methods to give precise statistical meanings to these facts,
see e.g. Campbell et al [3] and Cuthbertson [4].

IBM
140

Price

120
100
80

50

100

150

200

250

50

100

150

200

250

50

100

150

200

250

0.2

Returns

0.1
0
0.1
0.2

Volatility

0.8
0.6
0.4
0.2
0

Days

Figure 1.1: The IBM data.

returns using the whole time series and got the values

b = 8.38 104 and

b = 0.0234.
In Figure 1.2 is also drawn the normal density with mean
b and standard deviation
b. Looking at the figure it seems unlikely that data is normally distributed.
To convince ourself that this is the case, we will now conduct a test. For a random
X we let
2
E [X 4 ]
E [X 3 ]
and

=
.
1 =
2
Var(X)3
Var(X)2
If X is normally distributed, then one can show that

1 (2 3)2 As 2
W =n
+
(2)
6
24
(see Greene [7] p. 309). With our data set consisting of n = 267 observations we
get b1 = 0.6311 and b2 = 6.592. This gives
"
#
b1 (b2 3)2

c=n
W
+
= 171.6.
6
24
This value is so high that we can reject the hypothesis of normally distributed
returns on any reasonable level. This is due to the fact that the two lowest returns
are so extremely unlikely under the normality assumption. If we discard them,
arguing that they may have occurred on an extreme day, we have a sample of
0
0
n = 265 observations with new estimated values b1 = 3.225104 and b2 = 3.942.
c 0 = 9.813, and corresponds to a P -value of 0.0074. Thus, we can in
This gives W
this case reject the hypothesis of normality on all levels down to 0.0074.
2
3

IBM
45

40

35

30

25

20

15

10

0
0.12

0.1

0.08

0.06

0.04

0.02
Returns

0.02

0.04

0.06

0.08

Figure 1.2: The histogram of IBM returns and the fitted normal density.
When one finds that the model one is using is not in conformity with the data,
the natural thing to do is of course to modify the model. The first idea would
be to allow for a deterministic but time dependent volatility. It turns out that
although we do not have constant volatility any more, we still will have normally
distributed returns (this is shown in Chapter 3 below). To further expand the
model we can allow the volatility to depend both on time and on the state; by
state we mean the current stock price. State dependent volatility is random in
the sense that we do not know at time t what the volatility at same later time t0
will be. At time t however, the volatility for the next very short time epoch will
be approximately (t, St ), which is known at time t. In a stochastic volatility
model, however, the volatility is random in the sense that the volatility at time
t0 is totally unknown at some earlier time t. The above reasoning is heuristic,
but the idea is that the difference between the state dependent and the stochastic
volatility is that the former is locally known, while the latter model does not
have this feature. We can summarize the different models as follows, where the
complexity increases as we go downwards.
Constant volatility:

Time dependent volatility: (t)

Time-and state dependent volatility: (t, St )

Stochastic volatility: (t, )

We know that when we price contingent claims, we work under an equivalent
martingale measure. It is important to realize that when we change measure
4

from the original one to an equivalent martingale measure, we change the drift
but not the volatility of the stock price process. This is why we can use data
from the real world to improve our pricing models.
The aim with these lecture notes is to cover one lecture on stochastic volatility
to students familiar to the basic Black & Scholes model and the elementary
stochastic calculus needed to reach the risk-neutral valuation formula. Due to
this fact the list of references mostly consists of textbooks, and we refer to these
for research articles on stochastic volatility.

1.2

Assumptions and notation

To make the exposition easy we will only consider models on a finite fixed time
interval [0, T ], where T > 0. We will further assume that we have a given filtered
probability space (, F, P, (Ft )0tT ), were the filtration is the filtration generated
by the stochastic processes of our model. We will also assume that the drift
term of the stock price process is a constant times the stock price. There is
no real loss in generality in doing this, since we will mostly be concerned with
the behavior of the stock price process under equivalent (risk-neutral) martingale
measures. Unless otherwise stated, a contingent claim X is an FT -measurable
random variable fulfilling necessary integrability conditions. We also assume
that every process and stochastic integral we are considering is well behaved and
fulfills measurability and integrability conditions needed. We write X N (, 2 )
to mean that the random variable X is normally distributed with mean and
variance 2 .

Chapter 2
The Black & Scholes model
To get started we recall some facts about the model used by Black & Scholes
when they derived their formula for the price of a European call option.1

2.1

Valuation of contingent claims

The market is assumed to consist of risk-free lending and borrowing with constant
interest rate r and a stock with price process given by a geometric Brownian
motion. Let Bt and St denote the price processes of money in the bank and the
stock respectively and let Wt be a (standard) Brownian motion. The model can
then be written

dBt = rBt dt;

B0 = 1
dSt = St dt + St dWt ; S0 > 0,
where r > 0 (r > 1 is necessary), R and > 0. The theory of pricing
by no-arbitrage gives us the following expression for the price of the European
contingent claim giving the stochastic amount X at the expiration time T :
X (t) = er(T t) E Q [X|Ft ] , 0 t T,
where Q is the equivalent risk-neutral measure under which St is a geometric
Brownian motion with drift equal to rSt (Theorem 6.1.4 in Bingham & Kiesel
[2]).
To further simplify we will assume that X has the form X = f (ST ) for some
nice function f . To be able to write the price of X = f (ST ) in a more explicit
way, we start by noting that the solution to the SDE satisfied by St under Q is

2
St = S0 exp
r
t + Wt ,
(2.1)
2
1

Although (as is commented on in Bingham & Kiesel [2] p. 152 ff.) the model was not
invented by Black & Scholes, we will refer to it as the Black & Scholes model.

and we get

ST = St exp

2
r
2

(T t) + (WT Wt ) .

(2.2)

By using this and the Markov property of Ito diffusions we can write
"

#
2

X (t) = er(T t) E Q f St exp

r
(T t) + (WT Wt )
St

2
(recall that we have X = f (ST )). Equation (2.2) now gives that conditioned on
St we have

ST
2
2
Z = ln
(T t), (T t) .
(2.3)
N
r
St
2
Thus we can write

X (t) = er(T t) E Q f (St eZ )|St ,

where Z is the random variable defined above. For further use we let BS
X (t; )
denote the price at time t of the claim X, given that the stock price follows a
geometric Brownian motion with volatility .

2.2

Implied volatility

In the Black & Scholes model the price c of a European call option is given by
c = St (d1 ) Ker(T t) (d2 ),
where

2
2

+ r+
(T t)

and d2 = d1 T t.
T t
We wee that the price depends on the following six quantities:
d1 =

ln

S
t

todays date t,
the stock price today St ,
the volatility ,
the interest rate r,
the maturity time T , and
the strike price K.
7

The interest rate and the volatility are model parameters, the valuation time t is
chosen by us, and the stock price St is given by the market. The maturity time
and strike price, finally, are specific for every option. Among these quantities,
the only one that is difficult (indeed very difficult) to estimate is the volatility
. Now assume that we observe the market price of a European option with
maturity time T and strike price K. We denote this observed price by cobs (T, K).
With a fixed interest rate r and time t, implying that we also have a fixed St ,
we can write the theoretical Black & Scholes price of the call option as a function
c(, T, K). Since we cannot observe the volatility , a natural question is: given
the observed price cobs , what does this tell us about the volatility ?
Definition 2.2.1 The implied volatility I of a European call option is a strictly
positive solution to the equation
cobs (T, K) = c(I, T, K).

(2.4)

The implied volatility is thus the volatility we have to insert into the Black &
Scholes formula to get the observed market price of the option. Note that, with
r, t and St still being fixed, I is a function of T , K and the observed option price
cobs . In the definition of the implied volatility we speak of a solution to Equation
(2.4), and this raises the question of how many solutions there really are. This
issue is resolved in the following proposition.
Proposition 2.2.2 There can only exist at most one solution (i.e. zero or one)
to Equation (2.4), and if
cobs (T, K) > c(0, T, K),
then there exists exactly one strictly positive solution.
Proof. We have (see Bingham & Kiesel [2] p. 196)

c
log(St /K) + (r + 2 /2)(T t)

= St T t
> 0,

T t
so c is strictly increasing as a function of . Due to this fact, there will always exist
exactly one strictly positive solution to Equation (2.4) as long as cobs (T, K) >
c(0, T, K), and none if cobs (T, K) c(0, T, K).
2
Now also fix the time to maturity T . If the Black & Scholes model was correct,
the implied volatility would be equal to the constant volatility specified in the
model. Empirical results indicate that this is not always the case. The implied
volatility as a function of K is most often not a flat curve. Instead we can
typically get a smile (a U-shaped curve), a skew (a downward sloping curve),
a smirk (a downward sloping curve which increase for large K) or a frown
8

(an up-side-down U-shaped curve). The empirical evidence thus shows that the
market does not price European call options according to the Black & Scholes
model, that is, it does seem plausible for the volatility to be constant. This
leads us towards the models where volatility is not constant but dependent on
time.

Chapter 3
Extending the Black & Scholes
model
In this chapter we will discuss two extensions of the original model of Black &
Scholes that proceed the models with stochastic volatility. These extensions will
be used to bridge the gap between the original Black & Scholes model and the
ones with stochastic volatility.

3.1

Time dependent volatility

Let the stock price be modelled (under the risk-neutral measure Q) as

dSt = rSt dt + (t)St dWt ; S0 = s > 0,

(3.1)

where : [0, T ] (0, ) is a deterministic function. The value of the bank

account is again assumed to follow
dBt = rBt dt; B0 = 1.
The solution to the SDE governing the dynamics of the stock price is given by
Z t

Z t
2 (s)
St = S0 exp
r
ds +
(s)dWs .
2
0
0
Defining
1
2 (t, T ) =
T t

2 (s)ds,

we see that we can write the solution as

(
)
!
Z t
2
(0, t)
St = S0 exp
r
t+
(s)dWs .
2
0
10

Furthermore, we see that we have

(
)
!
Z T
2 (t, T )
(T t) +
ST = St exp
r
(s)dWs ,
2
t
and that the distribution of ln(ST /St ) conditioned on St is given by

n
o

ST
ln
N
r 2 (t, T )/2 (T t), 2 (t)(T t) .
St

(3.2)

Thus, with X = f (ST ) (again we assume that f is a nice function) we see,

comparing this expression with (2.3), that we can use the same pricing formula
as in the standard Black & Scholes case. We only have to replace 2 with 2 ,
and doing so we arrive at, for t T ,
q

BS
2
X (t) = X t; (t, T ) ,
where as usual X (t) denotes the price at time t of the contract X. Again
everything is easy to get hold of, except for the volatility. In this case, the
volatility is not merely a number, but a whole function. It turns out, however,
that given the implied volatilities on the market, it is possible to derive the
function (t).

3.1.1

Getting (t) from the implied volatility

By fixing a strike price K, we can look at the implied volatility as a function of

the time to maturity T only. It will of course also be dependent on the observed
options prices, but since these are given by the market, and not possible for us
to choose, we regard them as parameters and suppress their dependence on the
implied volatility. To conclude, we let I(T ) denote the implied volatility given by
the observed price of some European option with given strike price K and time
to maturity T .
By observing the implied volatility at some fixed time t0 as it varies over times
to maturity T , we can recover the time-dependent volatility (t) for t t0 . We
will make the assumption that there exists an option with maturity time T for
every T t0 . The idea is to equate the theoretical volatility under the model
given by Equation (3.1), the LHS in the next equation, with the observed implied
volatility:
s
Z T
1
2 (s)ds = I(T ).
T t0 t0
We can write this as

2 (s)ds = I 2 (T ) (T t0 ).

t0

11

Differentiating both sides with respect to T (recall that we have fixed t0 ) we get
2 (T ) = 2I(T )I 0 (T ) (T t0 ) + I 2 (T ).
By changing T t and taking the square root we get
p
(t) = 2I(t)I 0 (t) (t t0 ) + I 2 (t) for every t t0 .
Thus, what we have achieved is an explicit formula, showing how to extract the
volatility function (t) from the observed implied volatilities. The problem is,
from a practical point of view, that the assumption that there exists an option
which mature at any given time T t0 is unrealistic. Most often we only have
a finite number of maturity times for a European call option with strike price
K. By making the assumption that (t) is piecewise constant or linear we can
still be able to extract the information we want from the implied volatility. See
Willmott [8] Section 22.3 for more on this.

3.1.2

Conclusions

With the approach of a deterministic but time-dependent volatility we have

moved away from the constant volatility model of Black & Scholes. But we
see from Equation (3.2) that the returns still will be normally distributed. Since
this empirically is not the fact, we must move on, trying to find a model where
the returns are not normally distributed.

3.2

Time- and state dependent volatility

It is possible to model the volatility as (t, x), where we insert St in place of

x in the SDE for the stock price. The difference between this approach and
the stochastic volatility one is that although the volatility is random we do not
introduce any more randomness. The volatility is a function of St , which in
turn is driven by the Brownian motion Wt representing the only source of
randomness in our model. We can, as in the case with time-dependent volatility,
deduce (t, St ) from the implied volatilities I(K, T ) (now depending on both
strike price and maturity time). The function (t, x) consistent with observed
implied volatilities I(T, K) is called the local volatility surface. The calculations
in this case is more involved than in the time-dependent case and we do not
present them here. The interested reader is referred to Willmott [8] Sections
22.522.7.

12

Chapter 4
Models with stochastic volatility
The main idea with models where we have stochastic volatility is that we introduce more randomness beyond the Brownian motion driving the stock price.
In a sense the models where the volatility is state-dependent is also stochastic,
but for a model to be called a stochastic volatility model, we have to introduce
additional randomness.

4.1

The market model

The stochastic volatility model we will use is not the most general one, but it
will be sufficient for our purposes. For a slightly more general model see Section
7.3 in Bingham & Kiesel [2]. To begin with, let (Wt1 , Wt2 ) be a 2-dimensional
Brownian motion (remember that W 1 and W 2 then are independent) and let
(
dSt = St dt + (Yt )St dWt1; S0 > 0

p
(4.1)
2
1
2
dYt = m(t, Yt )dt + v(t, Yt ) dWt + 1 dWt ; Y0 given.
Here all functions are assumed to be well behaved. Especially we will demand
that (y) > 0 for every y R. The constant parameter , interpreted as the
constant instantaneous correlation between dSt /Stpand dYt /Yt , is further assumed
to fulfill [1, 1]. If we define Zt = Wt1 + 1 2 Wt2 then we can write
dYt = m(t, Yt )dt + v(t, Yt )dZt . Since W 1 and W 2 are independent Brownian
motions, Z is also a Brownian motion. It further holds that dhZ, W 1 it = dt.
The reason for not using (W 1 , Z) instead of (W 1 , W 2 ) is that we will make a
2-dimensional Girsanov transform later on, and then it is advantageous to have
two independent Brownian motions.
We think of Yt as some underlying process which determines the volatility.
Note that (Yt ) is the volatility of the stock price. We will use the short hand
notation t = (Yt ). A common belief is that volatility is mean-reverting. By
simply assuming that the volatility is a mean-reverting Ornstein-Uhlenbeck (OU)
process will get us into trouble since we would get negative volatility with positive
13

(y)
Yt
y
e
dYt = a(b Yt )dt + dZt

y
dYt = aYt dt + Yt
dZt

y dYt = a(b Yt )dt + Yt dZt

(OU)
(GBM)
(CIR)

Table 4.1: Examples of pairs of

p a volatility function and a process driving the
1
volatility. Here dZt = dWt + 1 2 dWt2 .

probability. Instead we could assume that Yt is an OU process and then let (y) =
ey , so that t = eYt , to avoid the problem of getting negative volatility. This idea
is carried through in Fouque et al [6]. Other examples of underlying process
Yt include the geometric Brownian motion and the Cox-Ingersoll-Ross process.
Finally we assume that the market contains a risk-free asset with dynamics
dBt = rBt dt; B0 = 1.

4.2

Pricing

To price contingent claims in this model we could either use the idea of constructing a locally risk-free portfolio and then equate the return of this portfolio with
the risk-free rate r, or we could look for an equivalent martingale measure. We
will not proceed according to first approach (the interested reader can find this
program carried through in Section 2.4 in Fouque et al [6]). Instead we will use
the equivalent martingale measure approach.
Before deriving a pricing formula, we must be aware of the fact that a stochastic volatility model is an incomplete model. Recall that we say that a model is
free of arbitrage if there exists at least one equivalent martingale measure. It may
happen in a model that is free of arbitrage that there are more than one equivalent martingale measure. If this is the case, we have to choose one of all these
measures to price the contingent claims. There is a vast literature on the subject
of choosing martingale measure when the underlying model is incomplete. For a
general introduction to the theory of pricing and hedging in incomplete markets,
see Bingham & Kiesel [2] Section 7.1 and 7.2 respectively.
We are now ready to approach the problem of pricing in this incomplete
stochastic volatility model. As in the original Black & Scholes model we change
measure, moving from our original measure P to an equivalent martingale measure Q. This is performed using a Girsanov transform, and since we have two
Brownian motions in our model, we make a 2-dimensional Girsanov transform.
Now recall that under an equivalent martingale measure, every discounted price
process should be a martingale. Looking at Equation (4.1), we see that in order
for the discounted stock price process to be a martingale under any equivalent
martingale measure it must have drift rSt under this measure; precisely as in the
14

original Black & Scholes model. If (Wt1 , Wt2 ), for t [0, T ], is a 2-dimensional
Brownian motion, then

Z t
Z t
1
2
1
2
f ,W
f )= W +
(W
1 (s, )ds, Wt +
2 (s, )ds , for t [0, T ],
t
t
t
0

is a 2-dimensional Brownian motion under the measure Q1 ,2 , where the RadonNikodym derivative dQ1 ,2 /dP is given by

Z T
Z T
Z

dQ1 ,2
1 T 2
2
1
2
2 (t)Wt .
1 (t)Wt
= exp
1 (t) + 2 (t) dt
dP
2 0
0
0
(This is theorem 5.8.1 in Bingham & Kiesel [2].) The previous discussion regarding the drift of the price of any traded asset under an equivalent martingale
measure implies that we have
r
(Yt ())
2 (t, ) = (t, ).
1 (t, ) =

Here is a stochastic process that we must choose. The theory gives, however,
no answer to the question of how we should choose . Since the process Y driving
the volatility is not the price of a traded asset, we need not impose the martingale
condition. Instead, and this is the core of incomplete models in terms of Girsanov
transforms, we can let be any enough regular process. Thus, for every choice of
we get an equivalent martingale measure which we can use to price contingent
claims. Looking at 1 , we see that this is the market price of risk. Due to this we
call the market price of volatility risk. Since the equivalent martingale measure
Q1 ,2 only depends on 2 = , we will denote it by Q . The expectation of a
random variable X with respect to the measure Q is denoted E [X]. We will
further let X (t) denote the price of the claim X at time t under the equivalent
martingale measure Q :
X (t) = er(T t) E [X|Ft ] .
Generally can be any (sufficiently nice) adapted process. If we make the additional assumption that has the form
t = (t, St , Yt ),
then we can derive a Black & Scholes-like PDE. Again assume that the claim we
want to price is given by X = f (ST ) for some function f . If we let
F (t, x, y) = er(T t) E [f (ST )|St = x, Yt = y] ,
15

then it turns out that F solves the following PDE:

2
2F
F

+ rx F
+ 12 2 (y) xF2 rF + v(t, y)x(y) xy
v(t, y)(t, x, y) F

t
x
y

1 2
2F
+ m(t, y) F
+
v
(t,
y)
2
y
2
y

=
0

F (T, x, y) = f (x),
where
(t, x, y) =

p
r
+ (t, x, y) 1 2 .
(y)

We see that is a (non-linear) combination of the market price of risk and the
market price of volatility risk. Note that the PDE above is a Feynman-Kac
PDE for the 2-dimensional diffusion (S, Y ). For a derivation of it using hedging
arguments, see Fouque et al [6] Section 2.4. We will now group the different parts
of this PDE.1
1.
F
F
1
2F
+ rx
+ 2 (y) 2 rF LBS ((y))F.
t
x
2
x
If this is set equal to 0, we get the ordinary Black & Scholes equation with
volatility (y). The differential operator LBS is often called the Black &
Scholes operator.
2.
v(t, y)x(y)

2F
.
xy

This term comes from the fact that we have correlation between the two
driving Brownian motions. If the correlation is zero (i.e. = 0), this term
disappears.
3.
v(t, y)(t, x, y)

F
y

This part comes from the risk premium of volatility.

4.
m(t, y)

F
1
2F
+ v 2 (t, y) 2
y
2
y

Recall that the (infinitesimal) generator AX of the diffusion

dXt = (Xt )dt + (Xt )dWt
1

The following comments on the PDE follows Fouque et al [6] p. 46.

16

is given by

1
AX f (x) = (x)f 0 (x) + 2 (x)f 00 (x).
2
From this we see that this last part of the PDE is nothing but the generator
of the volatility driving process Y .
Using the notation presented in the above list, we can write the PDE determining
the price of a contingent claim more compactly as

LBS ((y)) + v(t, y)x(y)

+ v(t, y)(t, x, y)
+ AY F = 0.
xy
y

4.3

Choosing the martingale measure

Since we must choose a process , how do we do it? The answer is that we have to
look at market prices, and from these prices try to estimate . In Fouque et al [6]
Section 2.7 the following scheme is suggested. Choose a model for the volatility
and assume that is a constant. Calculate the theoretical prices of European
call options with different strike prices and maturity times. Then go out to the
market and observe the actual prices cobs (K, T ) for these options. Finally use the
method of least-squares to estimate the parameters, i.e. solve the problem
X
(c(K, T ; ) cobs (K, T ))2 ,
min

(K,T )

where denotes the vector of parameters of our model, K is the set of strike pricematurity time pairs and c(K, T ; ) is the theoretical price for an European call
option with strike price K and maturity time T under the model with parameter
vector . Note that it may be hard to calculate these theoretical prices.

4.4

Uncorrelated processes

If there is no correlation between S and Y (i.e. = 0) we can use iterated

expectations to get back to the case with time-dependent volatility discussed in
Section 3.1 above. Again let the contingent claim be given by X = f (ST ). In this
case with two processes we must condition on the filtration generated by both
S and Y ; it is not enough only to consider the filtration generated by the stock
price process alone. Our filtration is in this case given by
Ft = (Su , Yu ; 0 u t) , t [0, T ].
Due to independence we can write2
Ft = (Su ; 0 u t) (Yu ; 0 u t), t [0, T ].
2

If F and G and are two -algebras, then F G denotes the smallest -algebra containing
all sets of F and G.

17

Since we cannot see into the future, the information generated by Y from t to T
is not in Ft . Let
{Y } = (Yt ; 0 t T )
denote the -algebra generated by the whole trajectory of Y from 0 to T . Then
Ft Ft (Yu ; t u T ) = {Y } (Su ; 0 u t), t [0, T ],
so the following equality follows from iterated expectations (the smallest algebra wins) and the Markov property
X (t) = er(T t) E [f (ST )|Ft ]
i
h

= er(T t) E E [f (ST )|{Y } (Su ; 0 u t)] Ft

i
h

r(T t)

= e
E E [f (ST )|{Y } (St )] Ft .
But the inner expectation is nothing but the Black & Scholes price with timedependent volatility (Yt ) at time t [0, T ], that is
s

Z T
1
t;
(4.2)
er(T t) E [f (ST )|(Y ) (St )] = BS
(Yu )du .
X
T t t
Combining this we get

t;
X (t) = E BS
X

4.5

1
T t

T
t

(Yu )du Ft .

Correlated processes

This case is not so easy as the previous one. We have to solve the PDE, which
may not be possible analytically. In Fouque et al [6] an approximate method for
solving the pricing PDE is presented. Their book (an excellent starting point for
the study of stochastic volatility) also contains a step-by-step guide to how to
use their method.

4.6

The leverage effect

A well known fact is that generally < 0 for stocks (i.e. is a negative correlation between return and volatility). That negative returns are associated with
increasing volatility is known as the leverage effect. The essence of the leverage
effect consists of the argument that a drop in stock price increase the volatility.
Assume that the value of a firm at one time is V . This value consists of the value
18

V (D) of the firms debts and the value V (E) of its equity: V = V (D) + V (E).
The equity is what is left of the firms value after having paid the debts. That is,
if we shut the firm down and pay back the debt then the equity is what is left.
Thus, if the firm has N number of stocks and the stock price today is S then
V (E) = N S and we have
V = V (D) + N S.
The leverage of a firm is defined as the proportion the debt has of the firm value:
Leverage =

V (D)
V (D)
=
.
V
V (D) + N S

Now assume that we have a drastic drop in the firms stock price. Then the
leverage increase, that is, the proportion of debt of the value increases. The firm
is now more sensitive against a negative change in the terms with its bond holders
(the ones who have borrowed the firm its debt). Thus, one could argue that the
firm should be considered a more risky one now than before the drastic drop.
Since we measure risk in terms of volatility, we expect the volatility to increase,
thus giving a negative correlation between the stock return and volatility.

19

Chapter 5
Hedging and stochastic volatility
This chapter is devoted to the question of what will happen if we believe that
the volatility is some constant , but the true volatility is given by the stochastic
process (t, ). The view we take is that of a hedger who wants to hedge his
position.1 In this chapter our market model is

dBt = rBt dt;

B0 = 1
dSt = St t + t St dWt ; S0 > 0.

5.1

The cost process

Assume that we have a strategy, specified by the number of bonds and stocks we
S
hold at time t, and denoted hB
t and ht respectively. Then the value Vt of this
portfolio at time t is given by
S
Vt = hB
t Bt + h t S t ,

and the dynamics of the value is given by (notice that we do not impose the
self-financing condition on our portfolio)
S
B
S
dVt = hB
t dBt + ht dSt + Bt dht + St dht .

Now define the cost process as

Z

Ct =
t

S
Bu dhB
u + Su dhu .

B
S
S
Then CT = 0 and dCt = (Bt dhB
t + St dht ). Given a strategy (h , h ) we
interpret Ct as the cumulated cost we have at time t in order to maintain our
strategy. With this definition we have
S
dVt = hB
t dBt + ht dSt dCt ,
1

For a more comprehensive study of this problem see Davis [5].

20

and we see from this that a portfolio is self-financing if and only if dCt = 0, which
is equivalent to CT Ct = 0. But since CT = 0, we see that we have in fact
proven the following proposition:
Proposition 5.1.1 A portfolio strategy (hB , hS ) is self-financing if and only if
the cost process associated with the strategy is identically 0.
Notice that given any process (t ) representing the number of stocks we want to
have at time t, and any process Vt representing the value we want the portfolio
to have at time t, we can always find a portfolio (, hB ) such that
Vt = t St + hB
t Bt for every t [0, T ]
B
(simply by letting hB
t = (Vt t St )/Bt ), but that in general the portfolio (, h )
will not be self-financing.

5.2

Hedging a call option

Now assume that we are faced with the following situation. We have sold a call
option with strike price K and maturity time T for an amount c0 at time 0,
and want to hedge this position. We believe that the volatility is some constant
, but the true volatility is given by the stochastic process (t, ). Thus, we
believe that the price of the option at time t, which we denote by Pt , is given by
Pt = F (t, St ), where F solves the Black-Scholes equation
F
2
+ rx F
+ 12 2 x2 xF2 = rF
t
x
F (T, x) = (x K)+ .
We hedge our position by using the delta hedge given by
t =

F (t, St ) F
(t, St )St
F
x
(t, St ) and hB
=
.
t
x
Bt

If was the true value of the volatility, then this (continuously rebalanced) delta
hedge is perfect in the sense that the value of our portfolio perfectly matches the
value of the option at any time t [0, T ]. This portfolio will generally not be
self-financing. The dynamics of P is given by
B
B
dPt = t dSt + hB
t dBt + St dt + Bt dht = t dSt + ht dBt dCt .

Using the Ito formula we get

F
1 2F
F
dt +
dSt +
dhSit
dPt = dF (t, St ) =
x
2 x2
t
F
1
F
2F
=
+ t2 St2 2 dt +
dSt .
t
2
x
x
21

The cost process associated with this strategy is thus given by, where we use the
expressions for t and hB
t from above,
dCt = dPt (t dSt + hB
t dBt )

2
F
F
F
1 2 2 F
F
dt +
=
+ t St
dSt
dSt + r F
St dt
t
2
x2
x
x
x

F
F
1 2 2 2F
=
dt.
+ rSt
rF + t St
t
x
2
x2
Now we use the fact that F solves the Black-Scholes equation, which means that
2
we can substitute the expression in the curly parenthesis with 21 2 St2 xF2 , to
arrive at

1 2F
dCt = St2 2 (t, St ) t2 2 dt.
2 x
Integrating this from 0 to T and using the fact that CT = 0 implies that
Z

1 T 2 2F
St
C0 =
(t, St ) 2 (t, ) 2 dt.
2
2 0
x
Since 2 F/x2 (the Gamma; see Bingham & Kiesel p. 196) is strictly positive
for a European call option we see that if t for every t [0, T ], then the
cost process is non-positive for every t, i.e. we will never have to add any money
in addition the amount c0 we got at time 0; we only have to collect the surplus
we gain on the hedge. But what should we choose? Obviously, the higher
constant we choose, the smaller the cost will be. But now recall that we have
sold the option at time 0 for the amount c0 . Let imp denote the implied volatility
representing the price c0 (we assume that the implied volatility is strictly positive,
see Proposition 2.2.2). Then we can think of this imp as the volatility we want
t to be below. To be concrete, let us consider the following example.
Example 5.2.1 Assume that someone wants to buy from us a European call
option with strike price 90 and maturing in 3 months. The price of the stock
today is 94, and the risk-free rate is 4.5 %. The volatility today is estimated to
be 35 %, and we believe that it will never go beyond 70 % during the 3 months
the option is alive. Using the Black & Scholes formula we get the following prices
(again c() denotes the price of a European call option in the Black & Scholes
model if the constant volatility is )
c(0.35) = 9.19 and c(0.70) = 15.37.
If the volatility was known to remain constant at 35 % the buyer would probably
not like to pay much more than 9.19. When the volatility is stochastic, it is likely
that he he is prepared to pay more than 9.19 (due to the uncertainty of future
volatility). But how much more is he prepared to pay? It is possible that when
22

presented with our suggestion of 15.37, he thinks that this is too high a price,
and that he is not willing to pay more than, say, 12.50. A call option price of
12.50 corresponds to an implied volatility of 53.84 %. Now we have to decide
whether to accept this offer or not. If we use the constant volatility of 53.84 %
when hedging, we may end up loosing money, even though the volatility stayed
below 70 %.
2

5.3

Hedging general contingent claims

One reason for the fact that we will always be on the safe side (i.e. having a nonpositive final cost C0 ) when we hedge a European call option using a constant
volatility that dominates the stochastic volatility t , is that the price function is
convex in the stock price. Going through the arguments of the previous section,
we see that we will have a non-positive final cost C0 if
(1) (t, ) for every t [0, T ], and
(2) the price function
F (t, x) = er(T t) E Q [f (ST )|St = x]
is convex in x.2

5.4

The Black-Scholes-Barenblatt equation

In this section we will consider the case when the volatility (t, ) is assumed to
belong to the band [, ]:
(t, ) for every t [0, T ],
where 0 < < < . We introduce the function

if x 0
U (x) =
if x < 0,
and let F + (t, x) be the solution to the equation
2 +
( +
2 +
F
F +
1
F
+
rx
+
U
x2 xF2 rF + = 0
t
x
2
x2
F + (T, x) = f (x).
2

Recall that a twice continuously differentiable function g is convex in x if

23

2g
x2

> 0.

Note that this is a non-linear PDE. It is called the Black-Scholes-Barenblatt

equation. We introduce U (x) for the reason that
2 + 2 +
2F +
F
F
t
U
2
2
x
x
x2
holds. Now assume that we have sold a claim at time 0 having the payoff X =
f (ST ), and consider the strategy consisting of holding
t =

F +
(t, St )
x

+
stocks at time t [0, T ], and letting hB
t = (F (t, St ) t St )/Bt . Then

Z
+

F (T, ST ) = F (0, S0 ) +

t dSt +
Z

= F + (0, S0 ) +

0
T

t dSt +
0

hB
t dBt + C0

r F + (t, St ) t St dt C0 ,

where C0 is the cost at time 0 of the strategy (, hB ). Itos formula on F + (t, St )

gives

Z T +
Z T
F
1 2 2 2F +
F +
+
+
F (T, ST ) = F (0, S0 ) +
+ St t
dt
+
dSt
t
2
x2
x
0
0
2 + 2 +
Z T +
Z T
F
F
F
1 2
F +
+
F (0, S0 ) +
+ St U
dt
+
dSt
t
2
x2
x2
x
0
0
Using the facts that F + solves the Black-Scholes-Barenblatt equation and that
we have t = 2 F + /x2 (t, St ) we get
Z
+

F (T, ST ) F (0, S0 ) +

r(F (t, St ) St t )dt +

0

t dSt .
0

But the cost C0 is nothing but the right-hand side minus the left-hand side of the
previous relation. Thus we have shown that with the strategy (, hB ) above we
are always guaranteed a non-negative cost if the volatility stays within the band
[, ]. A hedging strategy of this type, where the cost always is non-negative, is
known as a superhedge. In the previous section we showed how to hedge a claim
which is convex is the present stock price. The method described in this section
works for any claim as long as the volatility stays within [, ]. For more on this
approach see Avellaneda et al [1].

24

Bibliography
[1] Avellaneda, M., Levy, A. and Paras, A. (1995), Pricing and hedging derivative securities in markets with uncertain volatility, Applied Mathematical
Finance, 2, 73-88
[2] Bingham, N. H. & Kiesel R. (2000), Risk-Neutral Valuation: Pricing and
Hedging of Financial Derivatives, Springer-Verlag
[3] Campbell, J. Y., Lo. A. W. & MacKinley, A. C. (1997), The Econometrics
of Financial Markets, Princeton University Press
[4] Cuthbertson, K. (1996), Quantitative Financial Economics, Wiley
[5] Davis, M. H. A. (2001), Stochastic Volatility: the Hedgers Perspective,
Working Paper
[6] Fouque, J-P., Papanicolau, G. & Sircar, K. R (2000) Derivatives in Financial
Markets with Stochastic Volatility, Cambridge University Press
[7] Greene, W. H. (1997), Econometric Analysis, 3rd Ed., Prentice-Hall
[8] Willmott, P. (1998), Derivatives: The Theory and Practice of Financial
Engineering, John Wiley & Sons

25