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Pricing Basket

Options With Skew


Dong Qu
Quantitative Products Group—Derivatives & Structured Products—Abbey

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

3. Historic Basket Volatility Surfaces 1.5%

It is possible to construct a historic basket volatility surface from the his-


toric time series of the individual basket components. One such
1.0%

Basket Specific Risks Comments


0.5%
∂2P
Cross Gamma Risks The cross Gamma is defined as , i = j,
∂Si ∂Sj
where P is the basket option price, Si and Sj
0.0%
are the underlying spots. The cross Gamma 70% 90% 110% 130% 150%
specifies the delta change of i-th underlying
caused by the spot change in the j-th Figure 1: Historic PDF (Mean Drift = 9%).
underlying.
where N defines the time interval. The bucketed log-returns RT create the
Basket Correlation Risks When large moves occur in the market, historic PDF denoted as P . An example of a historic PDF is shown in Fig. 1;
the basket correlation tends to spike
and this will impact the pricing as well as risk Step 2: Recover the risk neutral PDF (Q ) from the historic PDF (P ). This is
parameters. This is also referred to as the a key step and a numerical optimisation technique is used for this. The
skewed correlation structure risks. penalty function for optimisation is based on a relative entropy, which is
a mathematical measure of the uncertainty of a distribution. The relative
Basket Volatility Skew Risks The basket volatility surface is largely driven entropy of Q to P is defined as follows:
by the volatility characteristics of the
individual components. It is also heavily S(P, Q ) = EQ (ln Q − ln P)
affected by the skewed correlation structure.
By minimising relative entropy S(P, Q ), one can solve for Q , subject to
FX Correlation Risks In a Quanto or Compo basket, the FX the following constraints,
correlation with each individual basket 
component will impact the price. Q (ST ) · ST · dST = Forward

Contractual Risks If merge and acquisition activity happens
Q (ST ) · dST = 1
to the basket member, the basket
composition will change and so will Additional optimisation constraint can also be applied, such as impos-
its volatility structure. ing the ATM volatility. The optimisation solution for the problem posed
Jump Risks In a large single stock basket, it is more above is:
likely that one or some of the basket
P(ST )
underlying default. The corresponding Q (ST ) =  exp(−λST )
underlying price may jump to zero. P(S) · exp(−λS) · dS

Where λ is a constant that can be obtained by iterating constraints dur-


approach is to minimise the relative entropy (ref. 6) in which a risk neu- ing the numerical optimisation. Note that given P(ST ) is always positive,
tral probability density function (PDF) for the basket can be built. Subject Q (ST ) is guaranteed to be positive. In Fig. 2, an example of risk neutral
to constraints of the forward and ATM implied volatility, the risk neutral PDF is shown and it is derived from the historic PDF shown in Fig. 1. The
PDF is used to construct a historic volatility surface for the basket. mean drift is the expected drift of the forward given the historic yield
Specifically, given the historic time series of the basket spot Si the fol- curve and dividends.
lowing steps are taken to build a historic basket volatility surface:
Step 3: Use the risk neutral PDF Q to obtain option prices with different
Step 1: Recover the historic PDF for the basket at time interval T by cal- strikes Ki :  ∞
culating the log-return at appropriate time interval: Call (Ki , T) = DF · (ST − Ki ) · Q (ST ) · dST
  
K
St+N K
RT = ln
^
St Put (Ki , T) = DF · (Ki − ST ) · Q (ST ) · dST
0

Wilmott magazine 59
1.5%

50%
1.0%
40%

0.5% 30%

20%
0.0%
70% 90% 110% 130% 150% 10%

Figure 2: Risk Neutral PDF (Mean Drift = 6.75%). 7.0


0%

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%

10% 4. Implied Basket Volatility Surfaces


7.0
0% It is conceivable that one can construct an implied basket volatility sur-
2.0 face from the implied volatility surfaces of individual basket compo-
50%

80%

110%

nents. One potential approach is to use the local volatility surfaces, in


140%

0.08
170%

which the stripped local volatility surfaces of the basket components


200%

can be integrated with appropriate correlation structures to build an


implied basket volatility surface. The local volatility approach is a small
Figure 3: FTSE Historic Vol Surface. step operation and can be computationally expensive. A more efficient

60 Wilmott magazine
TECHNICAL ARTICLE 2

technique (ref. 5) of constructing an implied basket volatility surface is 1.0


to use a copula alike technique, in large steps dealing with the terminal
distributions.

4.1. The Copula Technique to Construct Basket


Volatility Surfaces 0.5
In order to build an implied basket volatility surface, one needs to obtain
the joint distribution of the basket components. In general, however,
knowing the marginal distributions of the individual component and
the correlation structure does not guarantee an unique joint distribu-
tion. The copula technique allows us to specify a joint distribution func- 0.0
tion for known marginal distributions with a dependence (correlation) 0.0 0.5 1.0 1.5 2.0 2.5 3.0
structure. Specifically, for given univariate marginal distributions Fi (Si ),
Figure 6: Sampling CDF.
the Copula links the univariate marginal distributions to their multi-
variate joint distribution F(S1 , S2 , · · ·, Sn ) :
• Calculate either a call or put on the basket for a given strike K :
F(S1 , S2 , · · ·, Sn ) = C(F1 (S1 ), F2 (S2 ), · · ·, Fn (Sn ))
Call = E Max(SB − K, 0)
Given the implied volatility surfaces of each basket component, the
Cumulative Distribution Functions (CDF) at a chosen time slice for the Put = E Max(K − SB , 0)
individual component can be built and these CDFs are the univariate
• Calculate the basket implied volatility from either the call or put by
marginal distributions. If we impose correlation structures onto these
reversing the Black-Scholes formula (σB (K, T) = BS−1 (K, T)) .
CDFs and link them up using a Gaussian copula, the joint (basket) distri-
bution can be created as follows: The above steps can be repeated for different strikes (K ) and maturities
(T ) to build an entire basket implied volatility surface. It is important to
F(S1 , S2 , · · ·, Sn ) = C(CDF 1 (S1 ), CDF 2 (S2 ), · · ·, CDF n (Sn ))
note that in order to obtain a high quality basket implied volatility sur-
The joint distribution given above allows us to simulate the basket face using this technique, some numerical smoothing techniques are
spot path by sampling the correlated CDFs. Assuming there are n individ- needed in the process.
ual components in the basket, at a given time slice T , the following steps The constructed basket implied volatility surface could be used in a
can be taken to construct an implied basket volatility surface: variety of ways. Firstly, it allows one to quantify the basket skew and
hence analyse the skew exposures. Secondly, the basket can be treated as
• Build CDFs for all basket components at a chosen time slice T . This a new single underlying and other basket payoffs may be priced and risk
can be achieved by calculating digital calls or puts at the appropriate managed efficiently in a consistent manner using the same basket
strikes since a undiscounted digital option specifies the terminal implied volatility surface.
probability for the underlying spot to be above (call) or under (put)
the strike. The CDFs are obviously distributed between 0 and 1 and a 4.2. Basket Skew Under A Constant Correlation
typical CDF is shown in Fig. 6. The CDFs can be used later on to sam- In the following, we examine a basket of three underlyings. Their
ple the individual component spot path given a uniformly distrib- volatility surfaces are shown in Fig. 7, Fig. 8 and Fig. 9 respectively. The
uted random number; volatility surface for the underlying 1 has a relatively low ATM volatility
but strong skew. The volatility surface for the underlying 2 has a medi-
• Generate n independent random Gaussian numbers (gi ) and impose a
um ATM volatility with a medium skew. The volatility surface for the
correlation structure among them. This is a key step in which one
underlying 3 has a high ATM volatility with medium skew. The underly-
can either use a simple correlation number or skewed correlation
ing volatility surfaces are chosen to be representative to cover a wide
structure. If Cholesky decomposition technique is used, given the
range of possible market implied volatility surfaces. Fig. 10 shows the
decomposed correlation matrix Cij , the correlated Gaussian number
 constructed implied basket volatility surface using a constant correla-
is given by Gi = j Cij · g j ;
tion coefficient of 40%. As can be seen in figure, the basket skew is quite
• Convert the correlated Gussian numbers back to uniformly distrib- pronounced. The implied volatility points in the near right corner of the
uted numbers by reversing the Wiener process Ui = W −1 (Gi ) ; basket volatility surface for the short maturities and high strikes are not
• Use the correlated uniform numbers (Ui )to sample individual CDFs fully recovered. In practice, this is not a problem given that the missing
to obtain underlying spots (Si ), and in turn calculate the basket spot
^
 points are in the very low probability region and extrapolation into this
SB = ni=1 wi · Si ; region is relatively straightforward.

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

Figure 8: Implied Vol Surface (Underlying 2).


Figure 10: Basket Implied Vol Surface (Cor = 40%).
The correlation effect on the basket volatility is shown in Fig.11. The
implied basket volatility curves (volatility versus strike) at the time slice more negative) as the correlation increases. This is because the larger cor-
year 1 for different correlation coefficients (−20%, 0%, 50% and 90%) are relation makes the constituents of the basket move together more often
plotted in the figure. It is apparent that the higher the correlation, the and increases the probability of the basket spot reaching large extreme
higher the basket volatility level. This is a well understood fact as the values. The resulting probability density function can only be matched
higher correlations indicate that the basket components move more by that from an implied volatility curve with a larger skew. When corre-
coherently, resulting in the higher basket volatility. lation approaches 100%, the basket skew reaches maximum of −9.8% .
Fig. 11 also shows that the slope of the volatility curve changes with This is substantially less skewed than the most skewed underlying in the
the correlation. This indicates that the skew is also a function of the cor- basket which has a skew of −23.4% . Actually the basket skew is even less
relation. Fig. 12 plots the basket skew versus correlation at the time slice than the least skewed underlying which has a skew of −11.6% .
year 1. The basket skew is defined as the volatility slope at the strike of Let us now examine the full skew term structures. Fig. 13 plots the
100%. As can be seen in Fig. 12, the basket skew increases (slope becomes skew term structures of two basket underlyings and those of basket for

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).

figure, typically, when markets fall dramatically, they tend to fall


−25% together, indicating a much more correlated market move. A skewed cor-
relation structure incorporates the fact that the correlation becomes
larger when basket component spots are falling.
−20%
The skewed correlation structures can be built into the basket
Basket implied volatility surface during the construction process outlined in
−15% section 4.1. One such approach is to impose a linear correlation structure
Und 1
depending on where the average basket underlying spot is in a simulated
Und 2
−10% path. Fig. 15 plots three basket volatility curves versus strike for a basket
Und 3 of three underlyings. All curves are subtracted by the ATM volatility to
highlight the basket skew. The first curve is generated using a flat corre-
−5%
lation coefficient of 44% , which is chosen such that the basket ATM
volatility equals to that in the second and third curve illustrated below.
0% The second curve is constructed with a skewed linear correlation struc-
−20% 0% 20% 40% 60% 80% 100%
ture in the local volatility space in small steps. For each small step, the
Correlation
initial correlation of 40% is scaled up linearly to a maximum of 95%
Figure 12: Skew (1Y) vs Correlation. when the average of the basket underlying spots falls below the prevail-
ing average at the start of that small time step. It is apparent from the fig-
ure that the skewed correlation structure increases the slope of the bas-
ket volatility curve and the basket skew. The third curve is created also
different correlation coefficients (0% and 80%). Overall the basket skew
with a skewed linear correlation structure but using one big step, in
tends to be reduced compared with those of the basket underlyings. This
which the linear correlation coefficient (between 40% and 95% ) is
can be qualitatively understood from the central limit theorem. Given
dependent on half of the average of the terminal basket spot drop. The
the skew indicates a non-log-normality, and when there are more basket
large step approach is effectively an approximation to the small step local
underlyings contributing towards the joint distribution, the log-normal-
volatility approach. This can be clearly seen in the figure as the third
ity tends to be preserved and this reduces the skew.
curve is very close to the second curve.
4.3. Basket Skew Under A Skewed Correlation In practice, different practitioners may prefer to impose different cor-
Structure relation structures depending on different market views and hedging
In contrast to a constant correlation coefficient, a skewed correlation needs. The copula large step approach is flexible enough to allow various
structure illustrates a more complex but realistic relationship among the correlation structures to be incorporated into the basket. The correlation
^
basket components. Fig. 14 contains 10 years worth of historic spot time structure impact on the basket skew and basket pricing and risk expo-
series for FTSE-100, ESTX (EUROSTOCK 50) and S&P. As can be seen in the sures could be significant.

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

Figure 15: Basket Implied Volatility (1Y)

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

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