VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH
`
PIERRE HENRY-LABORDERE

Abstract. In this paper, we compute the sensitivity according to a (local) deformation of the
Dupire local volatility [6]. This leads to an efficient projection of the Vega risk on vanilla options
that we illustrate by numerical experiments.

1. Introduction
The market is assumed to be made of N assets, the values of which are modeled in a risk-neutral
framework by a local volatility model [6] (in short LV). Under the (unique) risk-neutral measure
P, the dynamics reads :
dSt = St (t, St )dWt , < dWt , dWt >= dt , = 1, . . . , N
with (Wt )=1,...,N an N -correlated Brownian motion. We denote (Ft ) as the natural filtration of
W . For the sake of simplicity, we have assumed zero (deterministic) interest rates and dividends.
This assumption can be easily relaxed by considering the local martingale ft as introduced in [10]
(see equation 14). As the market is complete, the risk associated to the pricing of an option can
be canceled via a proper delta hedging strategy. However, the implied volatility (in short IV)
dynamics produced by the LV model is not consistent with the market and the model needs daily
recalibration of the LV. As a consequence, the hedging strategy is sensitive to the deformation of
the IV: we say that we have a Vega risk. In principle, this risk could be canceled by an appropriate
portfolio of vanilla options with a continuum of strikes and maturities. However, the computation
of the weights for each vanilla options is quite challenging. The traditional approach involves
only an analysis of the global Vega risk associated to a parallel deformation of the IV surface. A
straightforward extension of this approach, the so-called super-bucket analysis, involves the shift
of each individual point of the IV [2]. However, this local deformation is not arbitrage-free: the
square of the LV function can become negative. Therefore, we must rely on a local deformation of
the LV function. This method can be quite time-consuming as we need to recompute the fair price
of the exotic and vanillas for each local deformation. Furthermore, this can lead to an ill-posed
problem as the sensitivity matrix may be non-invertible. In order to overcome these difficulties, we
suggest a new approach based on two steps: First an analytical expression of the vanilla weights in
terms of the local gamma leading to a well-posed problem and secondly a Malliavin representation
of this local gamma leading to a fast Monte-Carlo (MC) computation. The first step was also
independently investigated by B. Dupire [7]. Finally, we illustrate numerically our algorithm on
various payoffs.

Key words and phrases. Malliavin calculus, Functional derivative, Vega hedging, Local volatility model, Libor
Market Model.
1

Electronic copy available at: http://ssrn.com/abstract=2229990

`
PIERRE HENRY-LABORDERE

2. Vega Hedging
We consider an infinitesimal deformation of the LV (, ) (, ) +  (, ) and its impact on
the fair value of an exotic option O = E[] with a payoff = (St1 , . . . , Stn ) L2 (P) depending
on spot values at the dates {ti }i=1,...,n .
Assumption 1:
B = ( )=1,...,N are continuous twice differentiable functions with bounded Lipschitz derivatives
(in space) in order to ensure the existence of an unique strong solution.
B The matrix a := is assumed to satisfy an uniform ellipticity condition:
> 0 : X a(t, x)X |X|2 , (t, x, X) R+ (R+ )N RN
2.1. Local deformation. For use below, we introduce the Gateaux derivative [12] of O with
respect to this local deformation ()(, ):
Definition 2.1 (LV deformation). O is said to be Gateaux differentiable (along the admissible
direction +  satisfying the above uniform elliptic condition for any ) with derivative O
if the following derivative exists
O lim

0

O ( +  ) O()


Here O is seen as a map from a volatility function to R. Below, we note T K O (if it exists) such
that
Z tn
Z
O =
dT
dK (T, K)T K O
(1)
0

0
0
T K O

coincides with the Gateaux derivative along an infinitesimal local deformation

Formally,
(T, K) = (T T 0 )(K K 0 ) with () the Dirac function. The following result gives an useful
stochastic representation of T K O in terms of the so-called local gamma. For the sake of simplicity,
we first set our definition in the one asset case.
Definition 2.2 (Local gamma).
h
i
2
loc (T, K) E0 K
OT |ST = K 1tn T

(2)
h
i
with OT = E |FT .

In order to be more precise, loc (T, K) (T [ti , ti+1 ]) can be written as

Z
i
Y
2 p(ti+1 , Si+1 |T, K)
loc (T, K) =
p(tk , Sk |tk1 , Sk1 )p(T, K|ti , Si ) K
p(T, K|S0 )
k=1
n
Y

k=i+2

p(tk , Sk |tk1 , Sk1 )

n
Y

dSi

i=1

where p(tk , Sk |tk1 , Sk1 ) is the transition density (which exists under Assump. 1) from tk1 to
tk . In the multi-dimensional case, the local Gamma is defined as
K 2 (T, K)2
loc (T, K)

N
X
=1

h
i
E0 ST ST (T, ST ) (T, ST )S2 S OT |ST = K 1tn T
T

Electronic copy available at: http://ssrn.com/abstract=2229990

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

Proposition 2.3 (Stochastic representation). Under Assump. 1,

h
i

T K O = K 2 (T, K)
loc (T, K)E0 (ST K)
For the aim of readability, proofs have been reported in the appendix.
2.2. Exact Vega weights. We try to cancel the variations induced by these infinitesimal deformations on the LV using a portfolio of vanilla options with a continuum of strikes and maturities
with weights (, ):
N Z
X
=1

tn

dT 0

dK 0 (T 0 , K 0 )C (T 0 , K 0 )

with C (T, K) the market value (at t = 0) of a call option on asset with strike K and maturity
T . Note that by construction, the LV model is calibrated to these market prices. We get for each
= 1, . . . , N :
Z tn
Z
T K O +
dT 0
(3)
dK 0 (T 0 , K 0 )T K C (T 0 , K 0 ) = 0
0

as T K C (T 0 , K 0 ) = 0 if 6= . It is quite surprising that it is possible to get an analytical

expression for the weights in terms of the local gamma. This expression is also reported in [7].
Theorem 2.4 (Vanilla weights). Under Assump. 1,
(4)

(T, K) = LT K loc (T, K)

1 2
2 2
with L
T K T + 2 K (K ) the Fokker-Planck operator. The differentiations should be understood in the distribution sense.

We have added a subscript on to indicate that the deformation is performed around the LV .
Remark 2.5. It is obvious from the expression above that (T, K) = 0 for all T < t1 as
2
T p(T, S = K|S0 ) + 12 K 2 2 (T, K)K
p(T, S = K|S0 ) = 0.
Example 2.6 (Sanity check: European payoff (Stn )). We have
Z
2
loc (T, K) = (x)K
p(T 0 , x|T, K)1tn T dx
2
We obtain using (4) (T, K) = K
(K)(tn T ) as expected from a static replication strategy.

2.3. Smooth Vega weights. By construction, the weight (, ) is not a smooth function but a
distribution in D0 . In particular, for a call option with strike K 0 and maturity T 0 , one gets a Dirac
distribution (T, K) = (T T 0 )(K K 0 ) which is difficult to capture numerically.
2.4. Regularized kernel I. In order to overcome this numerical difficulty, we could smooth

0
0

:
(, ) by convolution with a regularized kernel (T , K |T, K) C
Z
Z
(T 0 , K 0 ) =

dT
dK (T 0 , K 0 |T, K)

(T, K)
0

`
PIERRE HENRY-LABORDERE

2.5. Regularized kernel II. A better alternative approach is to start from the fact that only a
small set of strikes and maturities are quoted on the market:
X
T ,K (ti , Ki )C(ti , Ki )
i,j

Here we have suppressed the subscript . Let us choose an interval [ti T , ti +T ][Ki K , Ki +
K ] centered on a (liquid) couple (ti , Ki ). Then as a heuristic choice, we take
Z ti +T
Z Ki +K
VBS (ti , Ki )T ,K (ti , Ki )
dT
dKVBS (T, K)LT K loc (T, K)
ti T

Ki K

with VBS (T, K) (resp. BS (T, K)) the Black-Scholes Vega (resp. Gamma) computed with the IV
T,K
BS
at (T, K). By using an integration by parts and the identities
T,K 2
LT K VBS (T, K) = BS
K BS (T, K)
T,K
VBS (T, K) = BS
T S02 BS (T, K)

we get
VBS (ti , Ki )

T ,K

(ti , Ki ) =

S02

Z

Ki +K

h
iti +T
T,K
BS
T BS (T, K)loc (T, K)
dK
ti T

Ki K

1
2
Z

ti +T

iKi +K 
T,K
T,K
T K 2 (T, K)2 loc (T, K)K (BS
BS (T, K)) + BS
BS (T, K)K (K 2 (T, K)2 loc (T, K))
dT
h

Ki K

ti T
ti +T

Ki +K

dT
ti T

T,K
dKBS
K 2 BS (T, K)loc (T, K)

Ki K

(5)

Each integral can be reduced to a quadrature on [0, 1]. Below, we examine a method to compute
numerically loc (T, K) based on Malliavin calculus (for a short introduction to Malliavin calculus with similar computations, see [11]) which was introduced in finance by [9]. An alternative
approach, using the It
o functional calculus introduced by B. Dupire, can be found in [8].
3. Computation of the local Gamma loc (T, K)
3.1. Black-Scholes representation. Note that when the transition density is known, as is the

case in the Black-Scholes model, with a constant volatility BS

, we get (T [ti , ti+1 ))
h 2 p(t , S |T, K)p(T, K|t , S ) i
i+1
i+1
i
i
loc (T, K) = E0 K
p(T, K|S0 )p(ti+1 , Si+1 |ti , Si )
In the multidimensional case, this reads

n
h S
X
(T ) KST p(ti+1 , Si+1 |T, ST (S = K))p(T, ST (S = K)|ti , Si ) i
T

(T,
K)
=
E

loc
K
(T )
p(T, S = K|S0i )p(ti+1 , Si+1 |ti , Si )
=1

This can be simplified a bit further using the explicit transition function:
h
p(ti+1 , Si+1 |T, K)p(T, K|ti , Si )
2
K 2 BS
(ti+1 T )loc (T, K) = E0 (S1 , . . . , Sn )
p(T, K|S0 )p(ti+1 , Si+1 |ti , Si )

i
1
1 + 2
2 1T [ti ,ti+1 ]
BS (ti+1 T )
where

= ln

Sti+1
K

1 2
+ BS
(ti+1 T )
2

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

In the multidimensional case, a lengthly computation leads to

h
p(ti+1 , Si+1 |T, ST (ST = K))p(T, ST (ST = K)|ti , Si )
2
K 2 (BS
) (ti+1 T )
loc (T, K) = E0 (S1 , . . . , Sn )
p(T, S = K|S0 )p(ti+1 , Si+1 |ti , Si )

i
1
1 + 2
(6)

(BS ) (ti+1 T )
with

!
!

Sti+1
1
ti+1 T BS
+ BS BS (ti+1 T )
=
ln
ti+1 ti BS
Sti
2
=1

 
 
Sti+1
T ti
K

ln

ln

Sti
ti+1 ti
Sti

 
  
 

Sti+1
Sti+1
1 2
T ti
K
ti+1 T
+ (BS ) (ti+1 T ) ln

ln
ln
=
ti+1 ti
Sti
2
Sti
ti+1 ti
Sti
M
X

3.2. Malliavins representation. In the general case, we need to rely on Malliavin calculus as
the probability density is not known. Here for the sake of simplicity, only results in the one-asset
case are written out. Extensions to the multi-dimensional case are straightforward.
Proposition 3.1 (Local Gamma). Under Assump. 1 and Cb2 (Rn+ ), we have

n
n
i
X
X
Y
Y
Y
t
t
t
(2)
(2)
i
j
|ST = K
i 2i (ti T )1tn >T +
ij
(7) loc (T, K) = E[
1
t
>T
n
YT
YT2
i=1
i,j=1
(2)

where the It
o (tangent) processes Yt and t
dYt

are defined by

= S (St (t, St )) Yt dWt , Y0 = 1

(2)
dt

(2)

S2 (St (t, St )) Yt (dWt S (St (t, St )) dt) , 0 = 0

i
For numerical purposes, (ST K) appearing in the conditional expectation E[|ST = K has to
be replaced by a Gaussian kernel  (ST K). Here we note that loc (T, K) depends on the Hessian
of the payoff, a quantity which could be quite difficult to compute numerically. This originates for
our irregular infinitesimal deformation irreg (s, Ss ) = (s T )(Ss K). We could compute the
local Vega O associated to a smooth deformation (s, S) (s, S) of the LV close to irreg :
Proposition 3.2 (Local Vega). Under Assump. 1,
n
h
i
X
(8)
O = E0 (St1 , . . . , Stn )
j
j=1

with
j

tj

tj1

tj

Ys
a(s)
dWs
S
(s,
Ss )
s
tj1

tj

(s, Ss )
(s,
Ss )
tj1


a(s)ds 1tj 1s (Ys S ln Ss (s, Ss ) 2s )(Zt0j Zs0 )

(Zt0j Zt0j1 )

and with a() such that

Z

tj

a(s)ds = 1 , j = 1, . . . , n
tj1

a(s)ds

`
PIERRE HENRY-LABORDERE

This expression requires the simulation of 5 It

o processes
dSt

= St (t, St )dWt

dYt

= S St (t, St )Yt dWt , Y0 = 1

(2)
dt

dZt0
(1)

dt

(2)

= S2 St (t, St )Yt (dWt S St (t, St )dt) , 0 = 0

St (t, St )
(dWt S St (t, St )dt) , Z0 = 0
=
Yt
(2)
1 = 0
= t dZt0 + (S (St (t, St )S St (t, St )) dt + S St (t, St )dWt ) ,
0

Remark 3.3 (Sanity check: Black-Scholes). Here we assume (t, S) = and (t, S) = . We get
Zt0
Yt

= S0 (Wt t)
St
=
S0

(2)

(1)

t
t

2
0


1
(2)
0
Zt0
S0

which gives the classical result

 i
n 
h
X
(Wtj Wtj1 )2
1

O = E0 (St1 , . . . , Stn )
(Wtj Wtj1 ) +
(tj tj1 )

j=1
(1)
Unfortunately, this expression requires the simulation of Zt0 and t for each deformation (, ).

For ease of implementation, we have decided to compute the weights for a constant volatility - say

BS
= 0.2. This is acceptable because if the weights depend strongly on the LV function (, ),
the Vega hedging should be unstable meaning that our Vega decomposition on vanillas should be
often re-balanced as the volatility changes.

Algorithm. Our algorithm can be summarized by the following steps for a payoff (St1 , . . . , Stn )
written on N assets.
(1) Simulate using constant volatilities ( i )i=1,...,N 1 and store the N assets at the dates
(ti )i=1,...,n .
(2) Compute the local Gamma using formula (6) or (7)2 on a space-time grid and then interpolate the result with splines. In practise, we take = 1/(12 2) and 100 points
min
max
in space. The range of the grid in space at T = k, i.e. [Sk
, Sk
], can
h be specified
max ] =
by looking at digital options computed with the constant volatilities: E0 1Sk >Sk
h
i
min
E0 1Sk <Sk
= 1 N (stdev) where N () is the normal cumulative distribution. We take
3 standard deviations.
(3) Compute the Vega weight as given by formula (5) (with K = 0.05, T = 1/(12 4)).

1This could be replaced by a time-dependent volatility i = i (t)

2In this case, the payoff need to be smoothed out.

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

4. Volatility sensitivities in Libor Market Models

4.1. Setup. In this section, we outline volatility sensitivities in Libor Market Models. This problem is close to the Vega hedging of exotic options in LV model that we have considered previously.
Let us denote Li (t) := L(t, ti1 , ti ) the forward rate resetting at ti1 with = ti ti1 the tenor.
As the product of the bond P (t, ti ) with the forward rate Li (t) is a difference of two bonds with
respective maturities ti1 and ti and therefore a traded asset, Li (t) is a (local) martingale under
Pi the forward measure associated with the numeraire P (t, ti ). In this measure, we assume that
the dynamics of Li (t) reads as
dLi = i (t, Li )dWti , < dWti , dWtj >= ij dt , i = 1, . . . , n
We consider an exotic option with payoff (L1 , . . . , Ln ) depending on the value of the Libors
L1 , . . . , Ln at a maturity date tn . Its fair value is given in the terminal forward measure Pn by
h
i
n
O = P (0, tn )EP0 (L1 , . . . , Ln )
We recall that the Libor dynamics is specified under Pn by
n
X
j (t, Lj )j
dt + i (t, Li )dWti , j = 1 . . . , n 1
dLi = i (t, Li )
ij
1
+

L
j
j
j=i+1
dLn

= n (t, Ln )dWtn

As each Libor volatility is sensitive only to a single caplet smile, we need only use a portfolio of
caplets with a continuum of strikes (with weights i ()):
n Z
X
dQi (K)C i (K)
i=1
i

C i (K) = P (0, ti )EP0 (Liti K)+ being the fair value of a caplet with maturity ti and strike K.
4.2. Vega hedging. We will consider the Gateaux derivatives i O along the local deformation
i (t, Li ) i (K)1t=ti . We note below (if it exists) i,K O satisfying
Z
i O =
i,K Oi (K)dK
0

Proceeding similarly as in Proposition (2.3), we obtain

n
k
j
X
n

(T
,
L
)
1
j
j
k OT k
kj
k,K O = i (K)P0tn E0P [(Lktk K)
2
k (T k , K)(1 + j Lj )
j=k+1

(9)

n
X

k
i (T k , Li )i<k<n ik
k , K)(1 + K)

(T
k
k
i=1

!
i OT k + 2

n
X
j (T k , Lj )
j=1

k (T k , K)

For a caplet option with maturity ti , this expression reduces to

k,K C i (Q)

h
i
k
i (K)ik (K Q)P0tk EP0 (Lktk K)

2 k
k (K)ik (K Q)K
C (K)

with ik the Kronecker symbol. Therefore by requiring that

n Z
X
i,K O +
dQk (Q) i,K C k (Q) = 0 , i = 1, . . . , n , K R+
k=1

kj OT k

`
PIERRE HENRY-LABORDERE

60%

50%
50%-60%
40%-50%
30%-40%
40%
20%-30%
10%-20%
30%
0%-10%
-10%-0%
20%

10%

0%

1.90
1.50

-10%

Figure 1. At-the-money call options,

2-janv.-12

0.30

2-mars-12

2-sept.-11

ST
S0

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

2-mai-10

2-juil.-10

1.10

+
1 , T = 1Y and T = 2Y.

we deduce
Theorem 4.1 (Caplet weights). Under Assump. 1
k2 (K) =

k,K O
2 C k (K)
k (K)K

The computation of the local Gamma (9) can be simplified if we perform the deformation of the
LV at i (t, Li ) = i ( i Li + 1). For such a choice, the processes Xti = i Lit + 1 defines a log-normal
diffusion for which we can obtain an expression similar to (6).

5. Examples
5.1. Numerical Tests.
5.1.1. European payoffs. First, we test our algorithm on European payoffs, mainly call options
(Fig. 1), call spread options (Fig. 2) and variance swaps (Fig. 3, 4) assuming a constant volatility
BS = 20%.
5.1.2. Exotic options. Then, we consider an Asian option (Fig. 5) and American digital options
(Figs 6, 7). Finally, as an example with two assets, we take a basket option with equal weights
(Fig. 9) and a worst-off option (Fig. 8). We have taken N = 218 Monte-Carlo paths. All graphs
show at a point (T, K) the product of the (Black-Scholes) Vega with the smooth weight (T, K).

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

30%

20%

20%-30%
10%-20%
0%-10%
-10%-0%
-20%--10%
-30%--20%
-40%--30%

10%

0%

-10%

-20%

-30%

1.90
1.50

-40%

Figure 2. Call spread options 95%-105%,

and T = 2Y.

ST
S0

2-janv.-12

0.30

2-mars-12

2-sept.-11

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

2-mai-10

2-juil.-10

1.10

0.95

+

ST
S0

+
1.05 , T = 1Y

Vega Weight
14%
14%

12%

12%
12%-14%
10%-12%
8%-10%
6%-8%
4%-6%
2%-4%
0%-2%
-2%-0%

10%

10%

8%

8%
6%

6%

4%
2%

4%
0%

1.90
1.50

-2%

2%

2-mars-12

2-nov.-11

2-janv.-12

2-mai-11

2-juil.-11

2-sept.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

2-mai-10

2-juil.-10

1.10
0.70
0.30

0%
0.30

0.50

0.70

0.90

1.10

1.30

1.50

1.70

2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12
VegaBS2Y/K^2

-2%

(2, K) at
Figure 3. 2Y log-swap. We have zoomed in on the Vega weights
T = 2 years and compared them again the Black-Scholes Vega divided by 1/K 2
as given by the static replication. We can see a perfect match.
5.2. Theoretical analysis of an example: Forward-start options. Let us consider a forwardstart option with payoff

+
St2
Q
St1
By using a Black-Scholes model with a constant volatility BS , the local Gamma is given by
Z
dS1
p(T, K|t1 , S1 )p(t1 , S1 |S0 )
loc (T, K) =
BS (t2 T, QS1 |K)
1T [t1 ,t2 ]
S1
p(T, K|S0 )
0

`
PIERRE HENRY-LABORDERE

10

14%
12%
12%
10%
10%-12%
8%-10%
6%-8%
4%-6%
2%-4%
0%-2%
-2%-0%
-4%--2%

10%
8%
8%

6%
4%

VEGAK 2Y
VegaBS/K^2
VegaK 1.9Y

6%

2%
4%
0%
2%
-2%

1.90
1.50

-4%

0%
0.30

0.50

0.70

0.90

1.10

1.30

1.50

1.70

1.90

2.10

2-janv.-12

-2%

0.30

2-mars-12

2-sept.-11

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-mars-11

2-nov.-10

2-janv.-11

2-mai-10

2-juil.-10

2-sept.-10

1.10

-4%

2
PT 
Figure 4. 2Y variance swap with monthly returns T2 i=1 ln SSi+1
. We have
i
(2, K) at T = 2 years and compared them again
zoomed in on the Vega weights
the Black-Scholes Vega divided by 1/K 2 as given by the static replication. We
can see a good match.

6%
4%-6%
2%-4%

4%

0%-2%

2%
-2%-0%
-4%--2%

0%

-6%--4%

-2%
-8%--6%

-4%

-6%

1.90
1.50

-8%

2-janv.-12

0.30

2-mars-12

2-sept.-11

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-mars-11

2-nov.-10

2-janv.-11

2-juil.-10

2-sept.-10

2-mai-10

1.10

Figure 5. 2Y geometric Asian option with monthly returns. Here the vega is
decomposed over a continuous density of options in strike and in time.

and BS (T, K|S) the Black-Scholes Gamma for a strike K, a maturity T and a spot S. From the
closed-form expression for the Gamma in the Black-Scholes model, the integration over S1 in the

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

11

European Digital T=2Y, K=1.3

300%

200%-300%

200%-300%

100%-200%

100%-200%

300%

200%

0%-100%

0%-100%

200%

-100%-0%

-100%-0%

100%
-200%-100%
-300%-200%

100%

-200%--100%
-300%--200%

0%

0%

-100%
-100%

-200%
-200%

1.9
1.5

1.8
-300%

0.3

2-mars-12

2-nov.-11

2-janv.-12

2-mai-11

2-juil.-11

0.7

2-sept.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

1.1

2-mai-10

2-nov.-11

2-janv.-12

0.3

2-mars-12

2-mai-11

2-juil.-11

2-sept.-11

2-nov.-10

2-janv.-11

0.8

2-mars-11

2-mai-10

2-juil.-10

2-sept.-10

-300%

2-juil.-10

1.3

Figure 6. American Digital T = 2Y versus European Digital option.

Ratio
300%

European 2Y
American 2Y

200%

100%

0%
0.3

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

-100%

-200%

-300%

Figure 7. Ratio between the Vega weights for the European and American digital
options. For a replication argument in the Black-Scholes framework, we expect a
ratio 2 [4]. Here we see a ratio 2.15.

last expression can be performed exactly and we get

2

loc (T, K)

1
q
K 2 2 2

BS

Q
t2 T + t1 1

t1
T

e

(t T )

(1 tt1 ) ln SK0 ln Q BS 22
t
2 2 (t2 T +t1 (1 1 ))
BS
T

!2

1T [t1 ,t2 ]

`
PIERRE HENRY-LABORDERE

12

2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12

Vega Weight
25%

20%

15%

10%

5%

0%
0.30

0.50

0.70

0.90

1.10

1.30

1.50

1.70

-5%


+
S1 S2
Figure 8. At-the-money Call on Max: max( ST1 , ST2 ) 1
with T = 2Y. 1,2 =
0

20%, = 50%.

2-mai-10
2-juin-10
2-juil.-10
2-aot-10
2-sept.-10
2-oct.-10
2-nov.-10
2-dc.-10
2-janv.-11
2-fvr.-11
2-mars-11
2-avr.-11
2-mai-11
2-juin-11
2-juil.-11
2-aot-11
2-sept.-11
2-oct.-11
2-nov.-11
2-dc.-11
2-janv.-12
2-fvr.-12
2-mars-12
2-avr.-12

Vega Weight
8%

7%

6%

5%

4%

3%

2%

1%

0%
0.30

0.50

0.70

0.90

1.10

1.30

1.50

1.70

-1%

Figure 9. At-the-money Basket with two assets,

2Y. 1,2 = 20%, = 50%.

 
1
2

1
ST
S01

2
ST
S02

+

, with T =

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

13

20%
15%-20%

10%-15%

5%-10%

15%

10%

0%-5%

5%
-5%-0%

-10%--5%

0%

-5%

1.90
1.50
-10%

2-janv.-12

0.30

Figure 10. At-the-money forward-start options,

t2 = 2Y.

2-mars-12

2-sept.-11

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

2-mai-10

2-juil.-10

1.10

St2
St1

+

, with t1 = 1Y and

Form this expression and Theorem 2.4, we deduce the weights BS (T, K). In particular at t1 and
t2 , we get
ln Q+

(10)

(11)

BS (t1 , K)

BS (t2 , K)

1
Q
p
e
2 (t t )
K 2 2BS
2
1

Q
1
q
K 2 2 2 t (1
BS 1

2 (t t )
BS
2
1
2

!2

2 2 (t2 t1 )
BS

((1 tt21 ) ln SK0 ln Q)

t
2 2 t1 (1 1 )
BS
t2
e

t1
t2 )

and a continuous density of options for intermediate maturities (t1 , t2 ). Equation (10) indicates
that the vega hedge at t1 corresponds to hold a strip of call options with a weight proportional
S
to 1/K 2 for a strike K. This can be synthesized by holding a log-contract with payoff ln St01 . We
have checked our analytical expression for the weights against our numerical algorithm (see Figs
10, 11). .

Conclusion
In this paper, we have designed an efficient algorithm to hedge the volatility sensitivity according
to a (local) deformation of the local volatility. A slight extension in the case of Libor Market
Models has been outlined.

`
PIERRE HENRY-LABORDERE

14

5%
4%-5%
3%-4%
2%-3%

4%
3%

1%-2%
0%-1%
-1%-0%
-2%--1%

2%
1%
0%

-3%--2%

-1%
-4%--3%

-2%

1.90
1.50

-3%
-4%

Figure 11. Call-spread forward-start options,

with t1 = 1Y and t2 = 2Y.

2-janv.-12

0.30

2-mars-12

2-sept.-11

2-nov.-11

2-mai-11

0.70

2-juil.-11

2-janv.-11

2-mars-11

2-sept.-10

2-nov.-10

2-mai-10

2-juil.-10

1.10

St2
St1

0.95

+

St2
St1

1.05

+

Acknowledgements
The author would like to thank his colleagues, in particular L. Bergomi and P. Carpentier for
fruitful discussions.

6. Appendix: Proofs
Proof Proposition 2.3. We set the proof in d = 1. The multi-dimensional case follows exactly the
O( 2 + ()2 )) satisfies the PDE
same arguments. O() (resp. O
1
t O + S 2 2 (t, S)S2 O = 0
2
+ 1 S 2 ((t, S) + ()(t, S))2 S2 O
=0
t O
2

(12)
(13)

By subtracting these two PDEs, we can formally apply the Feynman-Kac formula and get

O
O

Z
= 
0

tn

Z tn h
h
i
i
s ds + 1 2
s ds
E0 (s, Ss )(s, Ss )Ss2 S2 s O
E0 ((s, Ss ))2 Ss2 S2 s O
2
0

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

15

This representation follows from the uniqueness of weak solution of (12), (13) due to the uniform
ellipticity assumption (see [5] for details). By iterating this equation, we get
Z tn
h
i
O
O
dsE0 (s, Ss )(s, Ss )Ss2 S2 s Os ds
=

0
Z u
Z tn
h
i
u ()2 (s, Ss )S 2 2 Os ds
dsE0 ()2 (u, Su )Su2 S2 u O
du
+ 
s Ss
0
0
Z tn h
i
1 2
s ds
+
E0 ((s, Ss ))2 Ss2 S2 s O

2
0
By using Gaussian estimates for the fundamental solutions p (resp. p) of (12) (resp. (13)), (x, y =
ln S)


C
(x y)2
xk p(t, x|u, y)
exp
c
|t u|
|t u|(1+k)/2
one can show that the second and third terms goes to 0 when  0 (see Proposition 2.1 in [3]).
The key argument is that the constants c and C depends only on the uniform elliptic constant (not
on ), appearing in Assump 1. The Gateaux derivative is therefore
Z tn
h
i
O =
dsE0 (s, Ss )(s, Ss )Ss2 S2 s Os ds
0

By using the tower property, we have

O

E0 [(ST K)]K (T, K)

tn

dT
0

h
i
2
dK(T, K)E0 K
OT |ST = K 1tn T

from which we deduce T K O.

Proof Theorem 2.4. From Proposition 2.3, we get

Z
Z
h
i
0
0
0
2 T ,K
dT
dK 0 (T 0 , K 0 )E0 (ST K)K
(14) loc (T, K)p(T, K|S0 ) +
CT
=0
T
0
i
h
R
0
0
2
2 T ,K
CT
= p(T, K|S0 )K
p(T 0 , x|T, K)(x K 0 )+ dx
We note that by definition E0 (ST K)K
0
where p(T 0 , x|T, K) satisfies the backward Kolmogorov PDE
1
2
(15)
p(T 0 , x|T, K) = 0
T p(T 0 , x|T, K) + (T, K)2 K 2 K
2
with the terminal condition p(T, x|T, K) = (x K). Equation (14) becomes
Z
Z
Z
0
0
0
0 2
loc (T, K) +
dT
dK (T , K )K
p(T 0 , x|T, K)(x K 0 )+ = 0
T

By applying the Green operator LT K on both sides of the equation above, we get our final result
(4).

Proof Proposition 3.2. We deform locally the LV by
dSt =  (t, St )dWt , S0 = S0
where  (t, S) = (t, S) + (t, S) and the initial condition S0 = S0 . Here for ease of the presentation, (t, S) denotes a normal LV. Then, the process Zt =  St satisfies the SDE
(16)

dZt = (S  (t, St )Zt + (t, St ))dWt

with the initial condition Z0 = 0. Similarly, the tangent process Yt = S0 St satisfies the SDE
dYt = S  (t, St )Yt dWt

`
PIERRE HENRY-LABORDERE

16

with the initial condition Y0 = 1. Using Itos lemma, the solution of (16) is

 Z t
Z t
1
1





(17)
(s, Ss )(s, Ss )ds +
(s, Ss )dWs Yt
Zt =
 S

0 Ys
0 Ys
The payoff sensitivity with respect to  (i.e. local Vega) is
n
h
i
X
 O |=0 =
(18)
E0 i Zt0i
i=1

Plugging in this formula the solution (17) for

 O |=0 =

(19)

Zt0i ,

n
X

we obtain

E0 i Yti Zt0i

i=1

Using the Malliavin integration by part formula, the Vega can be represented as (see Proposition
3.3 in [9])
h
i
(20)
E0 ()
with
() =

n
X

(Zt0j Zt0j1 )

j=1

tj

tj1

Ys a(s)
dWs
(s, Ss )

tj

tj1

!
Ys a(s)
(Ds Zt0j Ds Zt0j1 )ds
(s, Ss )

Z
() denotes the Skorokhod integral of and Zt0 Y t0 . The function a() is such that
t
Z tj
a(s)ds = 1 , j = 1, . . . , n
tj1

Note that the Skorohod integral involves an infinite number of processes parameterized by s:
{Ds Zt0 }s[0,T ] . We explain how to reduce the complexity of this equation below.
We recall that
dZt0 =

(t, St )
(S (t, St )dt + dWt ) , Z00 = 0
Yt

for which we get

dDs Zt0

S (t, St )(s, Ss ) (t, St )Ds Yt

=
Ys
Yt2
(s, Ss )
(t, St )S2 (t, St )
dt
Ys


(S (t, St )dt + dWt )

s)
with the initial condition Ds Zs0 = (s,S
Ys . A straightforward computation shows that Ds Yt can be
written as


(s, Ss )
s
(s, Ss )
Ds Yt =
Ys S ln (s, Ss )
Yt +
t
Ys
Ys
Ys

with
dt

S2 (t, St )(s, Ss )

Yt2
dWt + S (t, St )t dWt
Bs Ys

and Ds Zt0 can be written as







(s, Ss ) 1
(s, Ss )s  0 0  (s, Ss )
0
1

D s Zt =
t s S (s, Ss )
Zt Zs +
1t>s
Ys
Ys2
Ys

VEGA DECOMPOSITION OF EXOTICS ON VANILLAS:

A MONTE-CARLO APPROACH

17

with
d1t

=
(2)

We note t

(t, St )t
(S (t, St )dt + dWt ) + (S ((t, St )S (t, St )) dt + S (t, St )dWt )
Yt2
t
Yt

and we get our final expression.

Proof Proposition 3.1 (see [1] for a close computation). We have seen in the previous proof that
the payoff sensitivity with respect to  is (see Equation 18)
 O |=0

n
X

i
h
E0 i Zt0i

i=1

n
X
i=1

 Z
h
E0 i Yti

ti

The second term can be written as

Z ti
i
h
1
(s, Ss )dWs
E0 i Yti
0 Ys

1
S (s, Ss )(s, Ss )ds +
Ys

=
=

Z
0

ti

i
1
(s, Ss )dWs
Ys

h
i
1
E0 i Yti ( (, S ))
Y
h Z tn
i
1
E0
Ds (i Yti ) (s, Ss )ds
Ys
0

In the first line, we have used that the Skorokhod integral of an adapted process coincides with the
It
o integral. In the second line, we have applied the Malliavin integration by part formula. With
the notations in the proof of Proposition 3.2, we get
n
h Z tn (s, S )(s, S )
i
X
s
s
(2)

(2)
 O |=0 =
E0

Y
(

)ds
i
t
t
s
i
i
Ys2
0
i=1
Z tn
n
i
h
X
Yt
+
E0 Yti ij
(s, Ss ) 2j (s, Ss )ds
Ys
0
i,j=1
Taking (s, Ss ) = K(sT )(Ss K) and replacing (s, S) by (s, S)S, we get our final result. 

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of Economics Universitat Pompeu Fabra (1999).
[2] Blacher, G. : Latest Advances in Pricing and Hedging Exotic Options, slides, Conference Summit (2001).
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Models, Communications on Stochastic Analysis, 2(1), 2008.
[4] Carr, P. Chou, A. : Breaking Barriers, Risk Magazine, pp. 139-45, Sept. (1997).
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epey, S.: Calibration of the local volatility in a generalized Black-Scholes model using Tikhonov regularization, SIAM Journal on Mathematical Analysis, 34 (2003), 1183-1206.
[6] Dupire, B. : Pricing with a Smile, Risk Magazine 7, 18-20 (1994).
[7] Dupire, B. : Hedging Volatility Risk, slides, ICBI conference (2008).
[8] Dupire, B. : Functional It
o Calculus, preprint, http://ssrn.com/abstract=1435551 (2009).
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e, E., Lasry, J-M., Lebuchoux, J., Lions, P-L, Touzi, N. : An application of Malliavin calculus to Monte
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ecis dAnalyse Fonctionnelle, Mir edition.

18

`
PIERRE HENRY-LABORDERE

te
Ge
ne
rale, Quantitative Research Global Markets, GEDS
Socie
E-mail address: pierre.henry-labordere@sgcib.com