Scribd
Upload
44 views1 page

Opengamma Local Vol - 006

This document discusses methods for time interpolation of volatility smiles fitted to FX option market data. It describes interpolating between common delta values rather than strike levels, to avoid issues from a lack of connection between volatility levels across expiries at a given strike. A proxy delta is defined to allow interpolation without time-consuming root finding. Log-log natural cubic spline interpolation of integrated variances is found to work best for interpolating between fitted volatility smiles at different expiries.

Uploaded by

Raj
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
44 views1 page

Opengamma Local Vol - 006

This document discusses methods for time interpolation of volatility smiles fitted to FX option market data. It describes interpolating between common delta values rather than strike levels, to avoid issues from a lack of connection between volatility levels across expiries at a given strike. A proxy delta is defined to allow interpolation without time-consuming root finding. Log-log natural cubic spline interpolation of integrated variances is found to work best for interpolating between fitted volatility smiles at different expiries.

Uploaded by

Raj
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 1

This means the first derivative is continuous for any choice of the weight function.

However the
second derivative can be discontinuous regardless of how smooth the basis function fi is:
2 ′ [ ′ ]
lim f ′′ (xi + ϵ) − f ′′ (xi − ϵ) = w (1) fi+1 (xi ) − fi′ (xi )
ϵ→0 ∆xi
[ ] (23)
2
− w′ (0) fi′ (xi ) − fi−1
′
(xi )
∆xi−1

If the additional constraint w′ (0) = w′ (1) = 0 is applied, then the second derivative will be
continuous. A candidate weight function is
( [ ( )] )
1 1
w(y) = sin π y − �+1 (24)
2 2

Extrapolation is handled by using either the SABR fit to the lowest three strikes (for strikes
less than the lowest market strike) or the fit to the highest three strikes (for strikes greater than
the highest market strike)7 .

3.1 Time interpolation


Clark [Cla11] points out that in FX markets there is no connection between the volatility levels
at a particular strike across expiries, and therefore it makes little sense to interpolate between
common strike levels from the smile fits in the time direction. Instead, time interpolation should
be performed between common delta values. If the volatility at some (T, ∆) is required, the
corresponding volatility at each fitted smile is found by root finding for the strike8 . Once these
volatilities are known, we can interpolate for the time T . An extra complication is that the PDEs
we will solve require the volatility at (potentially arbitrary) expiry and strike (or moneyness)
points, rather than expiry and delta, meaning we would have to iterate the above procedure to
find the delta and volatility at the required point. As this would be done several thousand times
to solve the PDE, it makes it impractical.
Clark [Cla11] suggests interpolating the ATM volatility, risk reversals and strangles9 to the
required expiry, then performing a smile fit from these interpolated values. This may require
performing 50-100 separate smile fits, and be liable to numerical instability.
To avoid time consuming root finding, we define a proxy delta as
(F )
ln K
d= √ (25)
T
The volatility of common d values on four adjacent fitted smiles is then found, and the integrated
variances computed. Note that the condition of equation 19 (i.e. integrated variance increases
with time) need not hold for these four values as we are not moving along a line of constant
moneyness. We find that a log-log natural cubic spline interpolation10 works best for the data
(however we note that this method can admit calendar arbitrage). Figure 1 shows the implied
volatility surface using this method.
7 With SABR there is a danger of getting arbitrage at very low strikes.
8 Of course, if the fitted smile was parameterised by delta in the first place, this root finding would be unnec-
essary.
9 The typical way FX volatilities are quoted.
10 taking the log of the time values and the log of the integrated variance, and interpolate these values.

You might also like