Q U A N T I T A T I V E F I N A N C E V O L U M E 3 (2003) 451457 INSTITUTE O F PHYSICS PUBLISHING

RE S E A R C H PA P E R
quant.iop.org

A new well-posed algorithm to recover implied local volatility

Lishang Jiang1 , Qihong Chen2 , Lijun Wang3 , Jin E Zhang4,5
1

Institute of Mathematics, Tongji University, Shanghai 200092, Peoples Republic of China 2 Department of Applied Mathematics, Shanghai University of Finance and Economics, Shanghai 200433, Peoples Republic of China 3 Department of Applied Mathematics, Tongji University, Shanghai 200092, Peoples Republic of China 4 Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong, Peoples Republic of China E-mail: jianglsk@online.sh.cn, chenqih@online.sh.cn, lhj-wlj@online.sh.cn and jinzhang@ust.hk Received 11 July 2002, in nal form 16 July 2003
Published 5 September 2003 Online at stacks.iop.org/Quant/3/451

Abstract
This paper presents a new algorithm to calibrate the option pricing model, i.e. the algorithm that recovers the implied local volatility function from market option prices in the optimal control framework. A unique optimal control is shown to exist. Our algorithm is well-posed. Our numerical experiments show that, with the help of the techniques developed in the eld of optimal control, the local volatility function is recovered very well.

1. Introduction
Based on the assumption of constant volatility, the famous BlackScholes formula can be used to evaluate European options simply and quickly by using the estimated or forecast volatility constant as an input [2]. The value of the option is monotonic in the volatility parameter. Then, most option traders invert the BlackScholes formula to determine the volatility (called the implied volatility) from the market option price. Actually, the BlackScholes formula has been used not so much as a pricing tool but as a means to switch back and forth between market option prices and their associated implied volatilities. If the model were perfectly realistic, the implied value would be the same for all options on the same underlying with different strikes and maturities. Unfortunately, this is not the case. Implied BlackScholes volatilities vary with strikes and time to maturity, which are respectively known as the smile effect and the term structure [21].
5

Author to whom any correspondence should be addressed.

There have been various attempts to extend the Black Scholes theory to account for the volatility smile effect and the term structure. One class of models introduces a non-traded source of risk such as jumps [19] or stochastic volatility [13]. A newer class of models introduces a deterministic volatility function that varies with the spot price and time. Rubinstein [22], Dupire [9] and Derman and Kani [8] have independently constructed a discrete approximation to the riskneutral process for the underlying in the form of a bi/trinomial tree, which are extensions of the original Cox et al [7] binomial trees. These implied trees are compatible with the observed smiles at all maturities and also keep the model complete. Bouchouev and Isakov [4, 5] reduce the identication of volatility to an inverse parabolic problem with the nal observation and establish uniqueness and stability results under certain assumptions. Then, they obtain a non-linear Fredholm integral equation for unknown volatility after dropping terms of the higher order of time to maturity and solve the equation iteratively. This approach is applicable to nding short-term volatility. If long-term volatility is the main interest, then one

1469-7688/03/060451+07$30.00

2003 IOP Publishing Ltd

PII: S1469-7688(03)39369-8

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Q UANTITATIVE F I N A N C E Problem I. Determine the coefcient, , such that the solution of (2.2) ts the current market prices of options at (s , t ) for different strikes, K, and/or maturities T . From the mathematical point of view, this is an inverse problem of partial differential equation (PDE). But it is not a standard one, since it requires us to determine the coefcient, , of the pricing equation by means of a series of observed values of the solution corresponding to certain parameters (K and/or T , which are usually discrete) at a xed point (s , t ). Such a problem is ill-posed in general. The fundamental issue of ill-posedness is the focus of Bodurtha and Jermakyan [3], who treat the problem from the classic Tikhonov perspective. With the derivation of a dual problem, the problem can be reduced to a standard parabolic equation with new variables:
1 u = 2 K 2 2 uKK (r q)KuK qu (K, ) R + R + , u|K=0 = eq s, u| =0 = (s K)+ ,

may be better off using an optimization-based algorithm. Lagnado and Osher [16, 17] suggest minimizing the gradient of the volatility function subject to a nite number of constraints. The gradient descent procedure is used to carry out minimization. The variational derivative has to be computed on each iteration step for all strikes and times to maturity and for each point on the nite difference grid. In other words, the fundamental solution for the BlackScholes equation must be computed in order to obtain the next volatility approximation. Consequently the computation could be highly demanding. Avellaneda et al [1] use the dynamic programming approach and minimize the entropy functional. A review of a few other optimization approaches can be found in [5]. This paper is a sequel to the paper by Jiang and Tao [14]. They use an optimal control framework to determine the implied local volatility and rigorously analyse the inverse problem. With a solid mathematical foundation well-established, we present a new algorithm to implement the procedure of calibrating the option pricing model, i.e. recovering the local volatility function from market option prices in the optimal control framework [10,11]. With the help of the techniques developed in the eld of optimal control, we have successfully recovered the volatility function. It turns out that, as an optimal control, the unknown volatility solves an elliptic bilateral variational inequality coupled with a forward and backward parabolic system. Our numerical experiments show that the volatility function is recovered very well.

(2.3)

where = T t is the time remaining to maturity. By rearranging the terms, we have Dupires [9] formula for the implied local volatility function: (K, T ) = u + (r q)KuK + qu . 1 2 K uKK 2 (2.4)

2. Related optimal control problem

As is well known [2, 12, 18, 23], when the stock price, s, follows a general diffusion of the form ds = dt + dWt , s (2.1)

where is the drift, is the stock volatility, and Wt is a standard Wiener process, the European call option premium, u = u(s, t; K, T ), satises the following BlackScholes equation:
1 ut + 2 s 2 2 uss + (r q)sus ru = 0 (s, t) R + [0, T ), u(0, t) = 0, u(s, T ) = (s K)+ ,

(2.2)

where T is the maturity, K is the strike, r is the risk-free interest rate, q is the dividend yield (on the stock) and is the stock volatility as in (2.1), which is the only parameter (in the pricing model) that is not directly observable. In recent years, many options became liquid (actually, we can now nd as many as a hundred simultaneously traded options on the S&P 500 index, all differing in strike price and/or time to maturity). With such plentiful data, the option market has become a rich source of information. It is thus natural to desire to recover the unknown volatility from the observed market price of options for different K and/or T at current time t with current stock price s . In the continuous-time setting, this amounts to the following problem.

In principle, we can infer the volatility function from the complete knowledge of the option price. That is to say, if the current market prices of the options are known for all conceivable strikes, K, and maturities, T , then the volatility function can be theoretically found directly from (2.4). But this method is not reliable for two reasons. The rst is that we need to evaluate numerical derivatives of u(K, T ) with respect to T and K, especially the second derivative with respect to K. A small change in u may result in a big change in its derivatives. Therefore, the computation might not be stable. The second reason is that the market option data only provide a set of discrete data points at (Km , Tn ), m = 1, 2, . . . , M, n = 1, 2, . . . , N. The value of u at some other point is obtained with an inter/extrapolation technique. It is therefore subject to some kind of error, which affects the nal value of the local volatility. Dupires formula (2.4) is found to be difcult to apply in practice. It therefore needs to be improved. We study the problem in two steps. First, we study the case when the local volatility is independent of time and use only option prices with different strikes and a xed maturity date in this paper. The case when the local volatility is also a function of time is left for future research. Thus, from above, this problem can be formulated as a typical inverse problem of parabolic equation with a terminal observation. Problem II. Find (K) such that the solution of (2.3) satises u(s , t ; K, )| = = u (K)

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Q UANTITATIVE F I N A N C E where = T t and u (K) is the current market price of options for different K > 0 at current time t with stock price s. In this paper, for the sake of compatibility, u (K) is assumed to be a continuous function satisfying
K0

A new well-posed algorithm to recover implied local volatility

Together with (2.7), (2.8) ensures that |v(y, ) v (y)|2 dy < ,

R

[0, ].

This makes it possible for us to dene a meaningful cost functional: J (a) = 1 v(, )v () 2 N 2 L2 (R) + 2 a
2 L2 (R) ,

lim u (K) = eq s ,

lim u (K) = 0.

(2.5)

The above problem is not well-posed either. However, with the standardized form, we are able to solve it in an optimal control framework. First, to remove the singularity at K = 0, we make a change of variables in (2.4): y = ln K , s v= 1 q e u, s

a A, (2.9)

where v is the solution of (2.6) corresponding to a. We now introduce the following optimal control problem. Problem III. Find an a A, such that J (a) = inf J (a).
aA

which leads to a Cauchy problem, v = a(y)(vyy vy ) (r q)vy (y, ) Q = R (0, ], v| =0 = (1 e ) ,

y +

(2.6)

where v(y, ) = 1 q e u(K, ), s a(y) = 1 2 (K). 2

Such an a, if it exists, is called an optimal control. The unusual feature of our problem is that the control variable lies in the coefcient of the second-order partial derivative in the pricing PDE and, moreover, the equation is in a non-divergent form. It is easily seen that J (a) is a non-negative lower semicontinuous functional and A is bounded in H lder space, o 1 2 (R). C Based on the state analysis, we can establish the existence and uniqueness for the above optimal control problem. Theorem 2.1. Problem III admits a unique optimal control, a A. A rigorous proof of the theorem is available in [14]. Recovering the unknown volatility is reduced to nding the optimal control of problem III. Now, we derive the necessary condition for the optimal control. Let a A be an optimal control of problem III and v be the solution of (2.6) corresponding to a. Note that A is a convex set, for any h A, (1 )a + h A For any h A, the function j () = J ((1 )a + h) [0, 1] [0, 1].

Under the above transformation, problem II becomes Problem II . Find a(y) such that the solution of (2.6) satises v(y, )| = = v (y), where v (y) =
1 q e u (K) s

satisfying (by (2.5))

y+

lim v (y) = 1,

lim v (y) = 0.

The solution to the above inverse problem, a(y), is dependent on s and just as v (y) is. Moreover, we further impose the following condition on the given data: |v (y) H (y)| dy < +,
2 R

(2.7)

is well dened and reaches its minimum at = 0. Then, we must have j (0) = i.e. d d d J ((1 )a + h)|=0 d 0

where H () is the well-known Heaviside function. Let A = {a C(R)| 0 < a0 a(y) a1 , a L2 (R)}

be the control set, where a0 and a1 are the lower and upper bounds of half the volatility squared respectively. The known theory for parabolic equations [15] guarantees that, for any given a A, there is a unique solution, v(y, ), to the Cauchy problem (2.6) with the property |v(y, ) H (y)| = O(e|y| ) (y ). (2.8)

[|v (y, ) v (y)|2

R

+ N |((1 )a + h)|2 ] dy |=0

h A, (2.10)

where v (y, ) is the solution of (2.6) corresponding to a = (1 )a + h ( [0, 1]).

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By direct differentiation with respect to on both sides of (2.6) for v , it can be veried that dv (y, ) d = (y, ),
=0

3. Numerical simulations
3.1. Algorithm
After summarizing the results of the last section, we have the following three sets of equations, state equation (3.1), adjoint equation (3.2) and variational inequality (3.3): v = a(vyy vy )(r q)vy , v| =0 = (1ey )+ ; (3.1) (3.2)

where satises the following variational equation: L a(yy y ) + (r q)y = (h a)(vyy vy ), | =0 = 0. (2.11) Thus, (2.10) gives [v(y, ) v (y)](y, ) dy
R

= (a)yy + (a)y + (r q)y , | = = v(y, ) v (y); a0 a a1 , 0, 0, (ayy + f (y; v, ))(a a0 ) (ayy + f (y; v, ))(a a1 ) where f (y; v, ) =

+N
R

a (h a) dy

h A.

(2.12)

(3.3)

Let be the generalized solution of the following adjoint equation: L (a)yy (a)y (r q)y = 0, | = = v(y, ) v (y).

(2.13)

1 N

(vyy vy ) d.

(3.4)

Then, from (2.11), (2.13) and Greens formula, we may deduce that
0 R

(L L ) dy d [v(y, ) v (y)](y, ) dy,

R

= i.e.,
0

Given the market price of option u (K) and the underlying s at time t , we would then determine v (y) by its denition v (y) = eq(T t ) u (K)/s . Our task becomes solving for a(y) from the three sets of equations. Once we have a(y), we would be able to get the volatility function by (s) = 2 a(ln s/s ). Given and v (y), the task of solving a(y) can be achieved by the following iteration procedure: (1) We make an initial value for a(y), say, a(y) = A0 (y). Solving equation (3.1) gives v(y, ). The algorithm for solving PDEs such as (3.1) and (3.2) is given in the appendix. (2) Assigning in v(y, ) obtained in step 1 gives v(y, ). (3) The difference between v(y, ) and v (y) gives the nal condition of | = . With this | = and the a(y) given in step 1, we can solve equation (3.2) to obtain (y, ). (4) With v(y, ) and (y, ), we can solve the variational inequality (3.3) to obtain a new function of a(y), denoted by A1 (y). The algorithm is also given in the appendix. (5) Justify the convergence of the iteration. Suppose is a prespecied error bound. If |A1 (y) A0 (y)| < , the iteration is nished. Otherwise we use A1 (y) as a new value for a(y) and return to step 1 and repeat the procedure until |An+1 (y) An (y)| < .

(h a)(vyy vy ) dy d
R

=
R

[v(y, ) v (y)](y, ) dy. Combining (2.12) and (2.14), we get

(2.14)

N
R

a (h a) dy

+
0 R

(vyy vy )(h a) dy d

h A. (2.15)

Equation (2.15) shows that a is a weak solution to the following elliptic bilateral variational inequality [6]: a0 a a1 , 0, 0, (2.16)

(ayy + f (y; v, ))(a a0 ) (ayy + f (y; v, ))(a a1 ) where

3.2. Numerical experiments

We have performed three numerical experiments in which the true volatility functions (denoted by p (s)) are prespecied as follows. (1) at volatility: p (s) = 0.25; (2) smile volatility: p (s) = (ln s ln 10)2 /40 + 0.2; (3) skew volatility: p (s) = (ln s ln 10)3 /80 + 0.2. In all three experiments, we use a at line, 0 (s) = 0.20, as an initial value. A few basic parameters are: q = 0, r = 0.12, a0 = 0.005, a1 = 0.045, 104 , s = 10 and = 1. In our numerical experiments, we rst solve equation (3.1) 1 with a(y) = 2 2 (s ey ) to get V (y, ). We treat u (K) =

1 (vyy vy ) d. (2.17) N 0 Consequently, we have obtained the optimality condition for our optimal control problem, as follows. f (y; v, ) = Theorem 2.2. Let a A be an optimal control of problem III and v be the corresponding solution of (2.6). Then, there exists a function solving the adjoint equation (2.13) such that a is a solution of the elliptic bilateral variational inequality (2.16).

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A new well-posed algorithm to recover implied local volatility

Table 1. Numerical results for the at volatility function.

s 100 (s) 100 p (s) 4 24.99 25.00 6 24.99 25.00 8 24.99 25.00 10 24.99 25.00 12 24.99 25.00 14 24.99 25.00 16 24.99 25.00 18 24.99 25.00 20 24.99 25.00 22 25.00 25.00 24 25.00 25.00

Table 2. Numerical results for the smile volatility function.

s 100 (s) 100 p (s) 4 22.30 22.10 6 20.99 20.61 8 20.52 20.13 10 20.38 20.00 12 20.43 20.08 14 20.60 20.28 16 20.83 20.56 18 21.10 20.86 20 21.39 21.20 22 21.72 21.55 24 22.06 21.91

Table 3. Numerical results for the skew volatility function.

s 100 (s) 100 p (s) 4 21.28 20.96 6 20.34 20.17 8 20.09 20.14 10 19.99 20.00 12 19.92 19.99 14 19.86 19.95 16 19.78 19.87 18 19.69 19.74 20 19.57 19.59 22 19.44 19.39 24 19.27 19.16

0.275 0.250 Volatility Volatility 10 0.225 0.200 0.175 0.150 0.125 5 15 Stock price 20 25

0.275 0.250 0.225 0.200 0.175 0.150 0.125 5 10 15 Stock price 20 25

initial condition 0 = 0.2, the solid line is the true volatility p = 0.25, the dots are the volatility that is recovered numerically by using our algorithm from the option prices generated with the true volatility.
K s eq V (ln s , ) as the given market value. Then, following the iteration procedure presented in the previous section, we solve the system (3.1)(3.3) with v (y) = V (y, ) to obtain A(y). By comparing the computed volatility function (s) = 2 A(ln s/s ) with the true function p (s), we are able to justify the accuracy of our method. Table 1 shows that, in the rst experiment, the relative difference between (s) and p (s) is uniformly smaller than 1104 . In the second experiment, the numerical computation converges quickly and the accuracy is on the order of 4 103 (see table 2). The third experiment works as well as the last experiment (see table 3). Figures 13 show the results of the three experiments.

Figure 1. The recovery of at volatility. The dashed line is the

initial condition 0 = 0.2, the solid curve is the true volatility p = (ln s ln 10)2 /40 + 0.2, the dots are the volatility that is recovered numerically by using our algorithm from the option prices generated with the true volatility.

Figure 2. The recovery of smile volatility. The dashed line is the

0.275 0.250 Volatility 0.225 0.200 0.175 0.150 0.125 5 10 15 Stock price 20 25

4. Concluding remarks
Calibrating the option pricing model is still an outstanding issue in nance, especially in the continuous-time setting. The difculty is due to the limitation of mathematical tools in dealing with the related inverse problem.

initial condition 0 = 0.2, the solid curve is the true volatility p = (ln s ln 10)3 /80 + 0.2, the dots are the volatility that is recovered numerically by using our algorithm from the option prices generated with the true volatility.

Figure 3. The recovery of skew volatility. The dashed line is the

In this paper, we solve the inverse problem of recovering the volatility function in an optimal control framework. With

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the existence and uniqueness of the optimal control established in [14], we present a necessary condition in a set of variational inequalities. We then propose an iteration procedure to solve the volatility function. Numerical experiments show that the numerical algorithm is stable and that it converges quickly. With the theoretical foundation well established, our method is now ready for both practitioners and researchers to test with market data and to price options.

A.2. Numerical scheme for variational inequality (3.3)

Given A0 (y), , vn (y) and n (y), we are now solving equation (3.3) for a(y), in which f (y; v, ) is dened by (3.4). Rearranging equation (3.1) gives vyy vy = [v + (r q)vy ]/a. Therefore, we have f (y; v, ) = 1 N
0

Acknowledgments
We wish to thank two anonymous referees for helpful comments and suggestions. JEZ is supported by the Research Grants Council of Hong Kong under grant CERG HKUST1068/01H.

[v + (r q)vy ]/a d.

For variational inequality (3.3), we introduce a false time variable t and obtain a parabolic bilateral variational inequality a0 a a1 , 0, 0 (A.6)

Appendix
A.1. Numerical schemes for PDEs (3.1) and (3.2)
For equation (3.1), for any a(y) = A0 (y), there always exist large numbers, L 1 and M 1, such that v(L) = 1 and v(M) = 0. By assuming v = (vn vn1 )/ , vn = v(y, n ), x = y + L, equation (3.1) is changed to vn (x) vn1 (x) A0 (y)[vn (x) vn (x)] + (r q)vn (x) = 0, v0 (x) = (1 exL )+ , vn (0) = 1, (A.1)

(at ayy + f (y; v, ))(a a0 ) (at ayy + f (y; v, ))(a a1 ) with initial value a|t=0 = A0 (y).

vn (L + M) = 0. Now, we use Meyers methods of invariant embedding [20] to solve this equation numerically. Let zn (x) = vn (x) and vn (x) = Un (x)zn (x) + un (x). (A.2) We have zn (x) = vn (x) = Un (x)zn (x) + Un (x)zn (x) + un (x). Substituting this into equation (A.1) and comparing the zeroorder and rst-order coefcients of zn (x) gives the following three ordinary differential equations: 1 r q + A0 (y) U 2 (x) Un (x), Un (x) = 1 A0 (y) n A0 (y) Un (0) = 0; (A.3) 1 1 un (x) = Un (x)un (x) + v1 (x)Un (x), A0 (y) A0 (y) un (0) = 1; (A.4) 1 r q + A0 (y) Un (x) + zn (x) A0 (y) A0 (y) 1 + [un (x) vn1 (x)], (A.5) A0 (y) un (L + M) zn (L + M) = . Un (L + M) Solving the above four sets of equations (A.2)(A.5) gives us vn (x) or v(y, ). The numerical procedure for equation (3.2) is similar to that for equation (3.1) and is thus omitted. zn (x) =

The asymptotic steady-state solution of parabolic variational inequality (A.6) will be the solution of elliptic variational inequality (3.3). Now, we implement the explicit nite difference method on (A.6): ain+1 a1 , n+1 ([(ai ain )/ t] (ain a0 ) ([(ain+1 ain )/ t] (ain a1 ) a0 Let
n n Bin = ai+1 +(12)ain + ai1 fi t, n n [(ai+1 2ain + ai1 )/( y)2 ] + fi )

0,
n [(ai+1

(A.7) 2ain +
n ai1 )/(

y) ] + fi )

0.

t/( y)2 .

Then, (A.7) becomes a0 ain+1 a1 , (ain+1 Bin )(ain a0 ) 0. 0,

(ain+1 Bin )(ain a1 ) Therefore, we have n Bi n+1 ai = a0 a1

if a0 < ain < a1 ; if ain = a0 and Bin < a0 ; if ain = a1 and Bin > a1 ,

where ai0 = A0 (yi ), = t/( y)2 1 and n is taken to be larger than 103 . By the computation above, we obtain the rst iteration, A1 (y), of a(y). If the difference between A1 (y) and A0 (y) is larger than the error bound, , we continue the iteration according to the same procedure.

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A new well-posed algorithm to recover implied local volatility [13] Heston S L 1993 A closed-form solution for options with stochastic volatility with applications to bond and currency options Rev. Financial Studies 6 32743 [14] Jiang L and Tao Y 2001 Identifying the volatility of the underlying assets from option prices Inverse Problems 17 13755 [15] Ladyzenskaya O, Solonnikov V and Uralceva N 1968 Linear and Quasilinear Equations of Parabolic Type (Providence, RI: American Mathematical Society) [16] Lagnado R and Osher S 1997 Reconciling differences Risk 10 (4) 7983 [17] Lagnado R and Osher S 1998 A technique for calibrating derivative security pricing models: numerical solution of the inverse problem J. Comput. Finance 1 1325 [18] Merton R 1973 Theory of rational option pricing Bell J. Economics Manage. Sci. 4 14183 [19] Merton R 1976 Option pricing when underlying stock returns are discontinuous J. Financial Economics 3 12544 [20] Meyer G 1973 Initial Value Methods for Boundary Value Problems (New York: Academic) [21] Rubinstein M 1985 Nonparametric tests of alternative option pricing models using all reported trades and quotes on the 30 most active CBOE option classes from August 23, 1976 through August 31, 1978 J. Finance 40 45580 [22] Rubinstein M 1994 Implied binomial trees J. Finance 49 771818 [23] Wilmott P 1999 Derivatives: The Theory and Practice of Financial Engineering (New York: Wiley)

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