Electronic copy available at: http://ssrn.com/abstract=1254102 Electronic copy available at: http://ssrn.

com/abstract=1254102
The Pricing of Path-Dependent
Structured Financial Retail Products:
The Case of Bonus Certicates
Rainer Baule
1
and Christian Tallau
2
Version: January 11, 2011
1
University of Siegen, Holderlinstrae 3, 57076 Siegen, Germany. E-Mail: rainer.baule@uni-siegen.de
2
University of Gottingen, Platz der Gottinger Sieben 3, 37073 Gottingen, Germany. E-Mail:
ctallau@uni-goettingen.de
This paper was formerly entitled, Is the Skew Priced in Structured Retail Products? Evidence from
the German Secondary Market. We thank Tom Aabo, Vivek Bhargava, Stephen Figlewski, Anthony
Hatherley, Olaf Korn, Markus Kre, Alireza Tourani-Rad, participants of the 21st Australasian Finance
& Banking Conference, Sydney, the 18th Annual Meeting of the European Financial Management As-
sociation, Milan, the Southern Finance Association 2009 Annual Meeting, Captiva Island, and seminar
participants at Auckland University of Technology, for valuable comments and suggestions.
Electronic copy available at: http://ssrn.com/abstract=1254102 Electronic copy available at: http://ssrn.com/abstract=1254102
Abstract
We investigate the pricing of bonus certicates, a popular type of structured nancial retail prod-
uct that features an embedded barrier option. Due to the path-dependency of these products,
a classical Black-Scholes valuation is problematic in the presence of the volatility skew. There-
fore, in addition to several variants of the Black-Scholes model, we consider the skew-consistent
stochastic volatility model of Heston (1993). We analyze how issuers price the volatility skew
and to what extent they are able to achieve a prot margin. Evaluating a data sample of 1,057
bonus certicates over a period of 22 months, covering 185,538 quotes, we nd that issuers
indeed employ a pricing model beyond the Black-Scholes framework. Analyzing the issuers
margins reveals that margins are relatively large compared to other structured retail products
with embedded plain-vanilla options. Average annualized margins range between 1.98% and
3.50% across the issuers. Furthermore, we nd that margins are a decreasing function of the
products lifetime, as well as a decreasing function of the moneyness. This moneyness eect has
a substantial impact on annualized margins: With the stock market decline in 2008 and the
corresponding decrease in average moneyness, average annualized margins increase from 1%2%
in 2007 to 3%5% in 2008.
Keywords: certicate, implied volatility, option pricing, stochastic volatility, structured nancial
product, volatility skew, volatility smile
JEL Classication: G13, G21
Electronic copy available at: http://ssrn.com/abstract=1254102 Electronic copy available at: http://ssrn.com/abstract=1254102
1 Introduction
Path-dependent derivatives, and barrier options, in particular, have played an important role
in the over-the-counter market between professional traders since the evolution of the equity
derivatives market. In the early years of the market, Merton (1973) provided a closed-form
solution for a down-and-out call option. Cox and Rubinstein (1985) and Rubinstein and Reiner
(1991) extended the pricing formula to all eight subtypes of barrier options. Some special types
of barrier options were also exchange-listed, albeit, with a rather limited volume of trading
(Chance, 1994).
Since the late 1990s, with the growing success of structured nancial retail products, new in-
vestment vehicles have been created that also exhibit path-dependent structures. While many
of these exotic structures have suered from the nancial crisis of 2008, some instrument types
could withstand the crunch. In particular, barrier reverse convertibles and bonus certicates are
still frequently being issued and purchased. Issuers are not able to directly hedge these instru-
ments in the options market, in contrast to products with embedded plain-vanilla options, as
there exists no exchange trading for barrier options. Therefore, choosing an adequate valuation
model for barrier reverse convertibles and bonus certicates is much more important than for
plain-vanilla products.
The valuation formulas in the mentioned seminal papers are based on the assumption of geomet-
ric Brownian motion of the underlying security, in particular, a at and constant volatility, and
are thus in line with the Black-Scholes (1973) option-pricing framework. Despite the widespread
use of this model in theory and practice, there is strong evidence that the assumption of a
at volatility does not hold in reality. Observed prices of traded options imply dierent Black-
Scholes volatilities, depending on the strike price and the time to maturity. In particular, the
implied volatility of many options on stocks and equity indices as a function of the strike price
1
exhibits a concavely decreasing shape known as the volatility skew. However, despite its inabil-
ity to account for this skew, the Black-Scholes model is commonly applied to price plain-vanilla
options by employing an implied volatility that corresponds to the particular strike price and
maturity date of the considered option.
While such an application of Black-Scholes is a feasible approach when information from the
market for plain-vanilla options is used to value other plain-vanilla options, it is highly ques-
tionable whether the implied volatility function obtained from traded plain-vanilla options is
directly transferable to the pricing of exotic instruments, particularly when the instruments
are path-dependent. Indeed, if the actual volatility is not constant, employing an average at
volatility may lead to severely biased model values of exotic options (Hull and Suo, 2002).
Simply employing dierent Black-Scholes volatilities for dierent strike prices, therefore, might
not be sucient to account for the volatility skew. A popular alternative is the model by
Heston (1993), which assumes a volatility which is itself stochastic. If the volatility is negatively
correlated with the underlying price, volatility tends to increase for decreasing underlying prices
and vice versa, which tendency is in line with the observed skew.
In this paper we ask how issuers address the problem of modeling barrier options embedded
in structured nancial products, and to what extent they are able to achieve a prot margin,
i.e., an additional charge on the fair value of these products. As issuers are typically market
makers for their own products, observed prices of retail derivatives at the secondary market do
not necessarily reect fair values, but rather the price-setting policy of the issuers. Hence, a
comparison of observed prices with calculated model values sheds light on the issuers pricing of
the considered product.
We examine whether issuers price the volatility skew consistently, based on a model beyond
the Black-Scholes framework. Therefore, we compare retail market prices quoted by the issuers
2
with theoretical values calculated with several variants of the Black-Scholes model and the
Heston model, the latter being representative of the class of skew-consistent approaches. In
particular, we examine which model explains the cross-section of retail prices most accurately
and is therefore most similar to the procedure applied by the respective issuer. Furthermore,
based on Heston model values, we analyze the magnitude, as well as the inuencing factors, of
the issuers prot margins. We focus on those bonus certicates
1
that comprise an embedded
down-and-out barrier option, since these products are issued on a large variety of underlyings
and aggregate a considerable market share of structured nancial retail products.
Several recent empirical studies have addressed the price-setting behavior of issuers. Our paper
is most closely related to the work of Stoimenov and Wilkens (2005), who analyze the pricing
of various types of retail derivatives, including barrier reverse convertibles. They nd evidence
that products with embedded exotic options are quoted at higher margins than those with plain-
vanilla options. However, their analysis is based solely on the classical Black-Scholes framework,
which is questionable for the above-mentioned reasons.
Similar concerns arise with an earlier study by Easton et al. (2004), who compare market prices of
plain-vanilla and barrier warrants on the Australian Stock Exchange with model values. They
also rely on the assumption of a at volatility. Furthermore, they do not consider the skew
by varying the volatility parameter for dierent strike and/or barrier levels. Based on their
restricted assumptions, they report that, on average, observed barrier warrant prices are greater
than theoretical values, while observed plain-vanilla warrant prices are less than theoretical
values.
Another type of structured nancial retail product that features an embedded barrier option is
the turbo certicate. In contrast to reverse convertibles and bonus certicates, turbo certicates
1
These products are also known as Participation Securities with Contingent Protection.
3
are highly leveraged and designed for short-term speculation. Muck (2006) points out the need
for more advanced models for analyzing turbo certicates. However, because they are similar
to common forward contracts, these products are rather insensitive to volatility. Wilkens and
Stoimenov (2007) analyze the margins on turbo certicates based on empirical data, and Entrop
et al. (2009) analyze them based on the pricing formulas communicated by the issuers.
Other papers dealing with the margins of structured nancial retail products focus on products
with embedded plain-vanilla options. Research on these products includes: in Switzerland,
Wasserfallen and Schenk (1996) (capital-guaranteed products), Burth et al. (2001) (reverse
convertibles and discount certicates), and Gr unbichler and Wohlwend (2005) (non-capital-
guaranteed products); in Germany, Wilkens et al. (2003) (reverse convertibles and discount
certicates), and Baule et al. (2008) (discount certicates); and in the U.S., Benet et al. (2006)
(reverse convertibles).
This paper is the rst to investigate the pricing of retail derivatives featuring path-dependent
options with a model that consistently takes the skew eect into account. It contributes to the
eld in several ways. First, we analyze the eect of the volatility skew on theoretical values of
bonus certicates. Second, we investigate how the volatility skew is considered by the issuers
price setting. Third, we analyze the margins of bonus certicates and their inuencing factors
with a skew-consistent option-pricing model.
The paper proceeds as follows. Section 2 describes the valuation of bonus certicates. We
review the Black-Scholes option-pricing framework and the Heston model for the valuation of
the embedded barrier option. We furthermore demonstrate the impact of the volatility skew
on model values based on an exemplary derivative. Section 3 presents the empirical data and
our methodology for calibrating the models. In Section 4 we report the results of our empirical
analysis. Section 5 concludes the paper.
4
2 Valuation of Bonus Certicates
2.1 Valuation by Duplication
At maturity T, a bonus certicate promises the holder an amount equal to the price of the
underlying security o
T
. Furthermore, if the underlying price has not reached (and has not fallen
below) a pre-determined barrier H at any point of time between issuance (T

) and maturity of
the certicate, a bonus payment applies in a way that the minimum repayment equals a bonus
level 1. Thus, the payo 1C
T
of the bonus certicate at maturity is given by
1C
T
= o
T
+ max{1 o
T
; 0}1
tT
, (1)
where t = inf{t T

: o
|
H} denotes the (random) time of the rst barrier passage, and
1
{}
is the indicator function. The payo scheme (1) can be duplicated by a long position in
a zero-strike call on the underlying security and a long position in a down-and-out barrier put
option.
2
If the underlying security pays no dividends within the lifetime of the certicate, the
value of the zero-strike call equals the underlying price. Provided no risk of default exists, the
value 1C

|
of the bonus certicate at any time t T is thus given by
1C

|
= o
|
+jdo
|
, (2)
where jdo
|
denotes the value of the down-and-out put option with barrier H and strike price 1.
However, given that bonus certicates are unsecured notes that may fail to pay in the event of
an issuers default, the value must be adjusted for this credit risk. We apply the model of Hull
and White (1995), which assumes independence between market and credit risk.
3
Accordingly,
the value is given by
1C
|
= 1C

|
c
c(T|)
= (o
|
+jdo
|
)c
c(T|)
, (3)
2
A zero-strike call represents a long position in the underlying with 100% nancing and no dividend entitlement.
3
See Baule et al. (2008) for a discussion of approaches to value structured products subject to credit risk.
5
where c denotes the credit spread of the issuer.
Whereas the underlying price can be readily observed for traded assets, there are no exchange-
traded barrier options available. We consider two dierent valuation approaches for the barrier
option. First, we employ the Black-Scholes framework, which provides a closed-form solution
for the barrier option value. Second, we consider the inuence of stochastic volatility within the
model proposed by Heston (1993). In contrast to the Black-Scholes approach, the Heston model
is able to consistently account for the volatility skew.
2.2 Black-Scholes Framework
Within the Black-Scholes option-pricing framework, the underlying price o
|
is assumed to follow
geometric Brownian motion under the risk-neutral measure,
do
|
o
|
= : dt +o d\
|
, (4)
where : is the risk-free interest rate, o is the at volatility, and \
|
is a standard Wiener process.
Using no-arbitrage arguments, the value of a down-and-out put option jdo
|
can be derived by
the following analytic formula (Rubinstein and Reiner, 1991):
jdo
|
= j
|
jdi
|
, (5)
where j
|
denotes the value of a plain-vanilla put option with
j
|
= 1c
(T|)
(d
1
+o

T t) o
|
(d
1
), (6)
where
d
1
=
ln(o
|
,1) + (: +o
2
,2)(T t)
o

T t
, (7)
and jdi
|
is the value of a down-and-in put option with
jdi
|
= o
|
(r
1
) +1c
(T|)
(r
1
+o

T t) +o
|
(H,o
|
)
2A
[(j) (j
1
)]
1c
(T|)
(H,o
|
)
2A2
[(j o

T t) (j
1
o

T t)], (8)
6
where
` =
: +o
2
,2
o
2
, (9)
j =
ln[H
2
,(o
|
1)]
o

T t
+`o

T t, (10)
r
1
=
ln(o
|
,H)
o

T t
+`o

T t, (11)
j
1
=
ln(H,o
|
)
o

T t
+`o

T t. (12)
As dened above, H denotes the barrier level, 1 is the strike price, and T t is the time to
maturity. () represents the cumulative normal distribution function. Except for volatility,
o, all parameters required for the valuation are readily observable. Besides applying historical
underlying price variations for the estimation, the volatility can be derived from quoted option
prices. This implied volatility represents the markets risk-neutral appraisal of future volatility
of the underlying asset over the lifetime of the option.
However, if market expectations about future volatility vary over dierent time horizons and
also depend on the development of the underlying price, the implied volatility function is not
at. For stock index options, in particular, the implied volatility usually exhibits a skew, such
that volatility decreases with increasing strike prices.
4
Practitioners often circumvent the problem of varying implied volatilities by employing dierent
volatilities for dierent strikes and maturity times in the Black-Scholes model. These volatilities
are implied by the prices of quoted options that most closely match the strike and the time to
maturity. However, for barrier options this procedure cannot be applied in a straightforward way
since these options are not actively traded and, hence, market prices for them are not observable.
Therefore, the implied volatility of plain-vanilla options has to be utilized as a proxy. As barrier
4
There is evidence that the skew is more pronounced for index options compared to individual stock options;
see e.g., Bakshi et al. (2003), Bollen and Whaley (2003), and Branger and Schlag (2004).
7
options are not only dened by the strike price, but also by a barrier level, it remains unclear
for which strike price this implied volatility should be calculated.
We examine three dierent plain-vanilla options to estimate the required volatility. First, we use
implied volatilities of at-the-money plain-vanilla options (at-the-money volatility). Second, we
employ implied volatilities of options where the strike price of the plain-vanilla option matches
the strike price of the barrier option (strike volatility). Third, we consider plain-vanilla options
with a strike price corresponding to the barrier level (barrier volatility).
2.3 Heston Model
The Heston model assumes that under the risk-neutral measure, the underlying price, o
|
, follows
the Ito process
do
|
o
|
= : dt +

|
d\
S
|
. (13)
In contrast to the geometric Brownian motion assumed by Black-Scholes, the variance,
|
, evolves
stochastically, following a mean-reversion process
d
|
= i(0
|
) dt +j

|
d\

|
, (14)
where i denotes the mean-reversion speed, 0 the long-run mean, and j the volatility of the
volatility. The changes in the underlying price and the volatility are correlated,
1
[
d\
S
|
d\

|
]
= j dt, (15)
with j being the correlation coecient. If the correlation is negative, the model is consistent
with the observed skew, because as underlying prices decrease, volatility tends to increase, and
vice versa.
The solution for the price of a plain-vanilla call option can be found using a Fourier transform
technique. This yields a semi-analytic formula involving the evaluation of a complex integral.
8
Within the integrand, a complex logarithm must be calculated with special care according to
the non-uniqueness of the complex logarithm. We follow the approach of Kahl and Jackel (2005)
for the numerical integration, using an adaptive quadrature method.
However, to value a barrier option within the Heston model, no such semi-analytic procedure is
feasible. Therefore, we apply Monte Carlo simulation. We prefer a simple Euler discretization
over more complex schemes because of the regularity of its convergence, which allows us to
apply Richardson extrapolation. If )
a
denotes the option value calculated with n time steps,
the Richardson extrapolated value is dened as ) = 2 )
a
)
a2
.
5
Using a Monte Carlo simulation of barrier options, the simulated (risk-neutral) probability of
hitting the barrier is downwards biased, because only a discrete set of time steps is considered.
The simulation disregards situations in which the underlying price is above the barrier at two
succeeding steps i and i +1, but hits the barrier at some intermediate point in time. Glasserman
(2004) therefore suggests calculating the probability,
i
, of such an intrastep barrier hit,

i
=

1 if min{o
i
, o
i+1
} < H,
exp
(
2
(S

1)(S
+1
1)
S
2

o
2

|
)
else.
(16)
The total probability of not hitting the barrier in one sample path is then given by 1 =

i
(1

i
). Employing this knock-out probability, , allows us to calculate a conditional option value
per sample path, dened as (1) times the discounted simulated payo max{o
T
1; 0}. With
this adjustment, the discretization error is substantially reduced. We can therefore use relatively
large time steps of 0.01 years.
6
The number of simulation runs applied is 100,000. For variance
reduction, we further use antithetic variables and control variates with the corresponding Black-
5
See Glasserman (2004), pp. 356358.
6
This value applies for the base case in the Richardson extrapolation, i.e., n = (T t)0.01 (rounded up to
the next even integer). Numerical tests have shown that the accuracy does not signicantly increase with smaller
time steps.
9
Scholes value.
2.4 Model Impact on Barrier Option Values
Before conducting our empirical investigation, we rst analyze the impact of the dierent models,
namely Black-Scholes and Heston, on barrier option values. In particular, we compare model
prices of the three considered Black-Scholes variants with those of the Heston model.
7
We consider a generic down-and-out put option with a period of one year to maturity. The
option has a strike price of 1 = 1 and a barrier at H = 0.6. To value the barrier option
within the Heston model, we employ a representative set of parameters with initial variance

0
= 0.02, long-run mean 0 = 0.05, mean-reversion speed i = 1.5, volatility of volatility j = 0.6,
and correlation coecient j = 0.6. The risk-free interest rate is set at : = 0.04. We obtain
corresponding Black-Scholes model values by calculating plain-vanilla option values using the
Heston model and employing the respective implied volatilities in (5). As described above, we
consider three dierent volatility estimates for the Black-Scholes model (strike volatility, barrier
volatility, and at-the-money volatility of plain-vanilla options).
[INSERT EXHIBIT 1 HERE]
Figure 1 displays the Black-Scholes and the Heston model values for dierent underlying prices.
For the Black-Scholes model with strike volatility, the barrier option value is overestimated,
compared to the Heston model, except for underlying prices near the barrier level. The model
with at-the-money volatility yields similar results. Only for in-the-money underlying prices are
the Black-Scholes values slightly lower than those for the Heston model. In the model with
7
For a similar analysis see Hull and Suo (2002). The authors report considerable deviations of the Heston and
Black-Scholes model values for dierent barrier levels.
10
barrier volatility, values for underlying prices close to the barrier are lower than in the Heston
model, whereas they are larger close to and above the strike price of the barrier option.
Especially for underlying prices at and somewhat below the strike price, where most certicates
are issued, any variant of the Black-Scholes model tends to overestimate the value of the down-
and-out put option and thus to also overestimate the value of the bonus certicate. The reason
for this is that volatility inuences the value of the down-and-out put in two ways. First, a higher
volatility increases the option value because of the asymmetric payo prole. Second, a higher
volatility decreases the option value according to the increased knock-out probability. If the
volatility structure exhibits a skew, the second (negative) eect is more pronounced, compared
to a at volatility. The eect is of signicant magnitude: Considering the at-the-money level,
model values for the at-the-money and strike Black-Scholes variant are around 50% greater than
for the Heston model, while the dierence exceeds 100% for the Black-Scholes barrier variant.
In such a situation, any choice of at volatility is inappropriate for explaining the barrier option
value.
The failure of the at volatility concept is also illustrated by Figure 2. This graph shows the
Black-Scholes value of the barrier option dependent on the volatility. In contrast to plain-vanilla
options, the function is not monotonic. As a consequence, the idea of implied volatility is not
feasible in this context; an implied volatility might fail to exist, or it might be not unique.
[INSERT EXHIBIT 2 HERE]
Therefore, the skew cannot easily be incorporated by simply utilizing the Black-Scholes frame-
work with dierent volatilities for dierent strike and/or barrier levels. Instead, to adequately
reect the skew, issuers have to apply an advanced model such as the approach proposed by
Heston. In the following, we investigate whether they actually do apply an advanced model, or
if they nonetheless rely on Black-Scholes and add a margin which is suciently high to avert
11
the risk of underpricing their products.
3 Data and Calibration
3.1 Certicates Data
Our empirical investigation is based on bonus certicates on the German blue-chip stock index,
DAX. The data set comprises bid and ask quotes for these products, traded on the German
market between November 1, 2006 and August 29, 2008. For each certicate, we obtain the last
bid and ask quotes on the respective day from the European Warrant Exchange (EUWAX). The
sample comprises 1,313 dierent certicates with a total of 212,040 pairs of bid-ask quotes. In
order to avoid biases due to small option time values, we restrict our analysis to certicates with
at least 30 calendar days to maturity. Additionally, we eliminate quotes from the sample for
which an implied volatility for the corresponding certicate could not be adequately estimated
from the options market. Furthermore, we focus on issuers with at least 50 certicates outstand-
ing. The remaining set includes 1,057 certicates and 185,538 bid-ask quotes. The composition
of the sample is given in Exhibit 3.
[INSERT EXHIBIT 3 HERE]
The average time to maturity at issuance amounts to 2.16 years. Since the issuance of bonus
certicates increased rapidly in 2007 and 2008, leading to a signicant share of recently issued
certicates, the eective average time to maturity of the sample is still comparatively high, with
a value of 1.74 years. The exhibit further provides information about average characteristics of
the certicates at issuance and at the observation dates. The moneyness, dened as the relative
dierence between underlying level and strike price, is negative on average with a value of 19%
at issuance and 12% at the observation dates. The relative distance to the barrier (cushion)
12
amounts to 25% at issuance and 29% at the observation dates. Finally, the exhibit reports
relative bid-ask spreads, calculated by relating the absolute spread to the midpoint of the bid
and ask quotes. The average spread of the total sample is fairly small, with a value of 0.11%.
However, we nd considerable dierences in the spreads across the issuers.
To value bonus certicates, we calculate the values of both components of the replicating port-
folio, the long zero-strike call and the long down-and-out put option on the DAX. Since the
DAX is dened as a performance index, where dividends are considered within its calculation,
the value of the zero-strike call equals the index level. We obtain the level of the DAX to the
tick at the time of each certicate quote from Frankfurts electronic trading platform (XETRA).
3.2 Market Data and Model Calibration
The value of the down-and-out put within the Black-Scholes framework is calculated by For-
mula (5). As mentioned above, the required volatility, o, is deducted from the implied volatility
function. We obtain daily settlement prices of call options on the DAX, traded at the EUREX
exchange. For each option, we further obtain the corresponding level of the DAX at the time
the settlement price is recorded. To determine the volatility for the valuation of a certicate, we
apply a weighting scheme by which we interpolate in the two-dimensional space formed by the
parameters time to maturity and strike price. Each interpolation involves implied volatilities
of four traded options of the two option series, with time to maturity closest above and closest
below the time to maturity of the respective certicate. Since we consider three versions of the
Black-Scholes model in terms of the applied implied volatility, we employ three strike prices:
For each series, we select those two options which are closest above and closest below (i) the
DAX at-the-money level, (ii) the strike, and (iii) the barrier level of the certicate. We use
the interpolated implied volatility in Formula (5) to calculate the barrier option model value.
13
Within this calculation, we use the level of the DAX at the time of the corresponding bid-ask
quotes for the certicate.
Risk-free interest rates are extracted from German government bonds. To estimate interest
rates that match the options time to maturity, we apply Svenssons (1994) extension of the
approach proposed by Nelson and Siegel (1987) in modeling the zero-coupon yield curve. The
Deutsche Bundesbank provides parameter estimates for the parametric Svensson function on a
daily basis. For the risk of issuer default, we deduce credit spreads from the iBoxx index for
corporate nancials with maturity in one to three years.
For the calibration of the Heston model, we apply the same information as for the Black-
Scholes model, i.e., daily settlement prices from call prices at the EUREX. There is no standard
calibration procedure for the Heston model. We follow Gatheral (2006), who suggests a stepwise
estimation of the parameters to obtain reasonable values as a starting point for an optimization.
First, the parameters i, j, and j are tted to the at-the-money skew. Therefore, we consider the
partial derivative of the Black-Scholes variance, o
2
1S
, with respect to a modied moneyness
8
: = :(T t) + log
o
|
1
, (17)
which is given by

:
o
2
1S
=
jj
i

(T t)

1
1 c
r

(T|)
i

(T t)
)
, (18)
where
i

= i
jj
2
. (19)
These model-implied skew values are tted to observed at-the-money skew values for dierent
maturities by minimizing squared errors. Then, the initial and long-term variance are tted to
8
The reasoning for this denition is that an option with strike price equal to the risk-free compounded stock
price, c
()
o

, has a moneyness of 0.
14
the at-the-money volatility term structure:
o
2
1S

1=c
()
S

= (
|
0

1 c
r

(T|)
i

(T t)
)
+0

, (20)
where
0

= 0
i
i

. (21)
Based on this initial parameter set, we t the observed implied volatility surface. To obtain
stable results, we apply a further two-step procedure. In the rst step, we deduce the volatility
level and skew for each EUREX option maturity and strike levels at-the-money, 20% in-the-
money and 20% out-of-the-money. In the second step, the Heston parameters are tted to this
volatility information by minimizing the sum of weighted squared errors between model and
market values.
9
By applying the described calibration procedure we obtain average parameter values as follows:
initial variance
0
= 0.0439, long-run mean 0 = 0.0656, mean-reversion speed i = 2.73, volatility
of volatility j = 0.881, and correlation coecient j = 0.693. Overall, the estimates are in line
with those obtained by other studies related to index options and stochastic volatility models
(e.g., Bakshi et al., 1997).
To quantify the over- or underpricing of a bonus certicate i, we compare the calculated Black-
Scholes (1o) and Heston (Hc) model values 1C
ncoc|
i,|
to the observed retail prices 1C
co-
i,|
. We
consider the relative price deviations,
\
ncoc|
i,|
=
1C
co-
i,|
1C
ncoc|
i,|
1C
ncoc|
i,|
, :odc| = 1o, Hc, (22)
and employ the mid-point of the bid-ask quotes as the observed price 1C
co-
i,|
. These relative price
dierences can be interpreted as the issuers gross margins (neglecting any operational costs).
9
The weighting is done in a way that for each combination of moneyness and maturity, the volatility level gets
a weight 5 and the skew gets a weight 1. Tests have shown that we get stable and reliable results with such a
weighting scheme.
15
Provided the adequacy of the modelwhich is calibrated to EUREX market pricesthe issuer
can buy the components of the certicate at a price 1C
ncoc|
i,|
, and sells it to the retail customer
at a price 1C
co-
i,|
. We expect the margins to be positive, at least near issuance, and to decline
during the lifetime of the certicate (see Wilkens et al. (2003), among others).
4 Results
4.1 Evolution of the Volatility Skew
Prior to the pricing analysis, we examine the magnitude of the volatility skew during the sample
period. Specically, we compare the implied volatilities of (synthetic) out-of-the-money, at-
the-money, and in-the-money DAX options with a period of one year to maturity. The strike
level of the out-of-the-money (in-the-money) option is set at 80% (120%) of the at-the-money
level. As described in Section 3, the implied volatilities of the synthetic options are obtained
by interpolating in the two-dimensional space formed by the parameters time to maturity and
strike price. Figure 4 displays the evolution of the resulting implied volatilities over the course
of the period of examination.
[INSERT EXHIBIT 4 HERE]
Obviously, the implied volatility exhibits a signicant skew; the mean dierence between out-
of-the-money and in-the-money volatility is 9.63%. Whereas the three implied volatilities under
examination increase on average over the course of the considered period, the dierence remains
fairly stable (standard deviation of 0.75% for the dierence of the out-of-the-money and in-the-
money volatility).
16
4.2 Average Margins
As an overview of the issuers price setting, Exhibit 5 reports the average margins, \
|
, as
dened by (22) between the retail prices and the model values of the bonus certicates for each
issuer. As discussed at the end of Section 3, margins are expected to be positive on average.
10
According to Exhibit 5, the total sample average margin of the Heston model is comparable
to the average margin of the Black-Scholes model with barrier volatility. Comparing the three
Black-Scholes variants, we nd a clear ranking order, where the barrier volatility version leads
to the highest average margins, and the strike volatility version to the lowest. Although the
margins vary across the issuers, these ndings still hold when considering the issuers separately.
Furthermore, we nd negative margins for the Black-Scholes variant with strike volatility. This
result provides a rst indication that issuers do not rely on such a model.
[INSERT EXHIBIT 5 HERE]
When we compare the margins of bonus certicates based on the Heston model with other types
of structured retail products, values for bonus certicates are fairly high. According to Exhibit
5, average Heston margins range from 2.09% (Commerzbank) to 4.85% (Goldman Sachs). In
contrast to these ndings, a recent study of discount certicates found average margins below
1%.
11
Observing larger values for bonus certicates is in line with Stoimenov and Wilkens (2005),
who report higher margins for more exotic instruments, compared to plain-vanilla structures.
However, the average remaining time to maturity of bonus certicates in our sample is also
larger than it is for typical discount certicates. The last column of Exhibit 5 reports average
annualized margins, dened as the relative price dierence, divided by the remaining time to
10
Note that models are calibrated using EUREX options and are applied to calculate margins at the retail
market. Hence, an adequate model does not necessarily lead to small values of \

.
11
See Baule et al. (2008).
17
maturity. Based on this measure, deviations between the issuers are still existent, although
smaller, having a range of 1.98% to 3.50%. The average value of 2.56% per annum, however,
remains large, compared to plain-vanilla instruments.
4.3 Explanation of Margins
In this section, we analyze the margins based on the four models in more detail. Besides eects
of the pricing model applied by the issuer, the margin is subject to several potential inuencing
factors. First, according to the life cycle hypothesis stated by Wilkens et al. (2003), margins on
the secondary market are supposed to be a decreasing function of the remaining time to maturity
of the certicate. It can be argued that while margins are positive at issuance, at maturity, they
must be at zero for transparency reasons; close to maturity, the value of the certicate nearly
equals its intrinsic value, which leaves no space for any surcharges.
In contrast to other studies, we do not focus on the relative lifetime, but rather on the absolute
remaining lifetime to maturity,
1
i,|
= T
i
t, (23)
which we incorporate as a regression variable. In our sample, we nd a much higher explanatory
power of 1
i,|
than of the relative lifetime. As part of the robustness analysis (see Section 4.5),
we also consider the relative lifetime.
Second, we include the moneyness
`
i,|
=
o
|
1
i
1
i
. (24)
For structured products with embedded plain-vanilla options, the moneyness has been found
to have an inuence on the margin in some cases.
12
The reason for this impact is that the
moneyness can be seen as a measure of the issuers leeway in incorporating a prot margin; for
12
See e.g., Wilkens et al. (2003).
18
high positive moneyness levels, the value of the barrier option is small, so the fair value of the
bonus certicate is close to the DAX level. For negative moneyness levels, the barrier option
valuewhich is not transparent for the investorincreases. If the issuer exploits this lack of
transparency to quote higher margins, moneyness should have a negative impact.
In addition to these two variables, we include the calendar time,
Y
|
= t t

, (25)
with t

being the beginning of the examination period (November 1, 2006), to control for po-
tential overall changes in the issuers price setting over the course of time. In summation, we
consider the following model for the relative margin:
\
i,|
= a
0
+a
1
1
i,|
+a
2
`
i,|
+a
3
Y
|
+c
i,|
. (26)
The statistical model is applied to the four pricing models (three variants of Black-Scholes and
Heston), for the total sample and separately for each issuer. First, in line with the life cycle
hypothesis, we expect the coecient a
1
on 1
i,|
to be signicantly positive. The corresponding
null hypothesis is H
1111
0
: a
1
= 0. Second, according to the moneyness hypothesis, we expect the
coecient a
2
on `
i,|
to be signicantly negative, which leads to the null hypothesis H
AO.1Y
0
:
a
2
= 0.
Furthermore, we utilize regression (26) to assess which pricing model is closest to the actual
price setting by the issuers. This is conducted via the standard deviation, :
1c-
, of the regression
residuals. The lower this standard deviation, the better the t of the linear regression to the
price dierences, and, hence the closer the respective model is to the issuers actual price-
setting model. The reasoning behind this judgement is as follows: If we calculate margins using
the same model as the issuer, the statistical relationship (26) should explain the margins exactly
(aside from unavoidable noise). If we apply a dierent model, deviations occur. Consequently,
19
the standard deviation of the regression residuals is a measure of how close a valuation model is
to the model that is actually applied by the issuer. Since the volatility skew is well documented
within the considered sample (see Section 4.1), if the issuer adequately accounts for the skew,
the margins implied by the (skew-consistent) Heston model should yield the best result in this
regard.
Within our data sample we deal with the problem that the observations are not independent.
Instead, for each certicate, the time series of price dierences exhibits a high degree of serial
correlation. To overcome this problem, for each certicate, we randomly select one single obser-
vation out of the respective time series. This selection is done by randomly drawing one trading
day for each certicate out of all days the certicate was traded within our time frame, from
November 2006 through August 2008. By doing this, we are able to consider the cross section
of certicates while covering the total sample period.
13
[INSERT EXHIBIT 6 HERE]
Regression results are provided in Exhibit 6. Numbers in brackets are the standard errors
estimated following a robust procedure that takes heteroscedasticity into account (White, 1980).
The standard deviations of the regression residuals indicate a ranking order of the four models.
Among the Black-Scholes models, barrier volatility is comparatively the best variant for four
out of the ve issuers, with :
1c-
ranging from 0.0094 to 0.0225. However, for all issuers, each
Black-Scholes variant is outperformed by the Heston model, with :
1c-
ranging from 0.0075 to
0.0151, showing a signicant improvement compared to the Black-Scholes regressions. These
ndings indicate that all issuers price the skew by a model beyond the Black-Scholes framework.
13
By this procedure, we are throwing away a lot of information for the sake of statistical rigor. As will
become clear in the empirical part, we nonetheless get signicant results. To analyze the inuence of this random
procedure, we repeated our analysis with other random samples, obtaining very similar results.
20
We therefore rely on the Heston model to explain margins in the following. First, we can
conrm the life cycle hypothesis for all issuers. The corresponding null hypothesis H
1111
0
is
rejected throughout at the 0.1% level. Hence, margins decrease when the certicate approaches
maturity. The slopes of this decrease, however, are quite dierent across the issuers, ranging
from 0.56% to 1.92% per year.
Second, we are also able to conrm the moneyness hypothesis, i.e., reject H
AO.1Y
0
, for all
issuers at the 0.1% level. Margins increase when the underlying price approaches the barrier.
The coecients take values from 3.79% to 8.23%. As a result, a drop in the underlying price
by 10% of the strike levelequivalent to a decrease in moneyness by 0.1leads to a rise in
margins by 0.38% to 0.82% on average. A possible explanation for this eect, which is caused
by the price-setting behavior of the issuers, is that due to negative values of the moneyness, the
lack of transparency of the barrier option value becomes more pronounced. Issuers could tend
to exploit this lack of transparency and quote a higher margin when the actual value of the
certicate is less obvious. But this margin surplus can also be seen as a necessity for the issuers.
Issuers themselves face the risk that their model for valuing and hedging bonus certicates may
not be completely accurate. With decreasing moneyness and increasing value of the barrier
option, this model risk becomes more pronounced. As compensation for this risk, issuers might
tend to charge a higher margin. So, both the lack of transparency for investors and the model
risk for issuers are possible explanations for the observed eect.
The moneyness eect has a substantial impact on average margins. With the decline of the stock
market in 2008, the moneyness of all certicates decreased, leading to an overall margin increase.
Exhibit 7 shows average monthly annualized Heston margins and average monthly moneyness
for the total sample over the course of our sample period. While in 2007, average annualized
margins are relatively small (1%2%), they increase substantially to values of 3%5% in 2008.
21
This margin increase is very well in line with the decrease in moneyness. The two monthly
time series are negatively correlated with a correlation coecient of 0.95. Furthermore, the
monthly standard deviation of annualized margins increased considerably in 2008. With the
stock market decline, more and more certicates reached the lower barrier, and their bonus fea-
tures were knocked out, after trading close to the barrier for a while. As the valuation of barrier
options is particularly dicult in these situations, both model risk and lack of transparency are
disproportionally high, leading to higher margins and standard deviations.
[INSERT EXHIBIT 7 HERE]
4.4 Do Issuers Apply Black-Scholes?
The results presented so far support the hypothesis that the issuers indeed consider the skew
in their pricing of path-dependent structured retail products by deploying a model beyond a
simple Black-Scholes variant. However, it has not yet been statistically conrmed, and the
comparatively good explanatory power of the Black-Scholes variant with barrier volatility raises
some doubt as to whether the results can withstand rigorous testing.
Theoretically, identifying the pricing model closest to the issuers could be similar to a factor
analysis. One could try to simultaneously regress observed retail prices onto all considered model
values while controlling for the identied inuencing parameters. One could then identify the
actually applied pricing model by the signicance of the regression coecients, similar to factor
loadings. But since the absolute model values are highly correlated, multicollinearity would
render such an approach useless.
We must therefore modify the approach in such a way that we consider the model variants
separately. Furthermore, as in the preceding analysis, we rely on relative price dierences rather
than on absolute prices. Specically, we test if the issuers apply one of the Black-Scholes variants,
22
without further considering the skew eect, using a regression of the form
\
1S
i,|
= c o11\
i,|
+a
0
+a
1
1
i,|
+a
2
`
i,|
+a
3
Y
|
+c
i,|
. (27)
The null hypothesis is c = 0.
To make the variable o11\
i,|
operational, we utilize the Heston model. As the Heston model
accounts for the skew, the relative dierence between the Heston value and the respective Black-
Scholes value is a suitable measure for the inuence of the skew on the certicate value. We
therefore dene
1
i,|
=
1C
1c
i,|
1C
1S
i,|
1C
1S
i,|
(28)
and run the regression
\
1S
i,|
= c1
i,|
+a
0
+a
1
1
i,|
+a
2
`
i,|
+a
3
Y
|
+c
i,|
(29)
for each of the three Black-Scholes variants.
If issuers account for the skew beyond the Black-Scholes framework, the coecient c for the
variable 1
i,|
representing the skew-consistent Heston modelis signicantly positive. Further-
more, the coecient should be exactly 1 if the issuer relied on the Heston model (as specically
applied in this study). However, as there are various ways to calibrate the Heston model, and
since other models can also account for the skew, we expect c to be only approximately 1.
We employ the same randomly selected observations as above. Regression results are reported in
Exhibit 8. Again, numbers in parentheses are the standard errors, which are estimated following
the procedure proposed by White (1980). First, and most striking, the coecient c for the model
dierence is signicantly positive at the 0.1% level for all issuers and models. Thus, the null
hypothesisissuers apply a Black-Scholes variant without further considering the skewcan be
rejected for each of the three model variants.
[INSERT EXHIBIT 8 HERE]
23
Furthermore, the regressions yield values for c that are close to 1 in most of the cases. With
respect to Black-Scholes, with barrier volatility as the most promising variant, for the institutions
BNP Paribas, Goldman Sachs, and Societe Generale, the null hypotheses c = 1 cannot be
rejected at the 5% signicance level. These ndings conrm that these issuers actually apply a
model that leads to results similar to the Heston model with the described calibration procedure.
4.5 Robustness
To check the robustness of the results, we conducted the same analysis with dierent random
samples, all of which lead to fairly similar results. We also ran the same regressions as described
above with modied explanatory variables.
First, instead of employing the absolute remaining lifetime, 1
i,|
, we consider the relative remain-
ing lifetime to maturity,
11
i,|
=
T
i
t
T
i
T

i
, (30)
with T

i
being the time of issuance. Second, instead of using the moneyness, `
|
, we apply the
cushion to barrier, C
i,|
, dened as the relative distance of the current stock price, o
|
, and the
barrier level, H
i
,
C
i,|
=
o
|
H
i
o
|
. (31)
For both alternatives to the main approach, we obtain fairly similar results, although with
decreased signicance of the coecients of the modied variables. The standard deviation, :
1c-
,
of the regression residuals is still the lowest for the Heston model, and coecients of the relative
model dierence, 1
i,|
, are still signicantly positive, with values close to 1.
24
5 Conclusion
This paper is the rst to investigate the price setting for bonus certicates, a popular type
of retail derivative that features an embedded barrier option. We examine in particular how
issuers price the volatility skew and to what extent they are able to achieve a prot margin
for such a path-dependent structured nancial retail product. In addition to the widely used
Black-Scholes model, we employ the Heston stochastic volatility model, which is able to account
for the well-documented volatility skew.
A theoretical analysis of a generic barrier option reveals that Heston and Black-Scholes model
values dier considerably depending on the underlying price and the employed estimate for the
Black-Scholes stock price volatility. These ndings cast doubt on the adequacy of a Black-
Scholes-type model in valuing bonus certicates. Indeed, when assessing the considered models
by their power to explain observed retail prices, measured by the standard deviations of regres-
sion residuals for the relative margins, the Heston model outperforms all three Black-Scholes
variants. By applying a rigorous statistical test, we can conrm indications that issuers incor-
porate the volatility skew in their price setting, i.e., they deploy a valuation approach beyond
the plain Black-Scholes model.
Our ndings suggest that an analysis of structured nancial products with embedded path-
dependent structures, particularly barrier options, should not be based solely on Black-Scholes.
In this sense, the paper joins the work of Muck (2006), which argues for the necessity of applying
more advanced models for the valuation of turbo certicates.
Although we can conclude that issuers account for the skew beyond the Black-Scholes approach,
we have no proof that they actually rely on the Heston model. Since the calibration of the
Heston model involves ve parameters for which several calibration approaches are applicable,
the calibration will introduce some kind of noise. Even if an issuer relies on the Heston model,
25
calibration issues may lead to biases in model values. Moreover, there are other skew-consistent
option-pricing models, such as extensions of the Heston model (e.g., which allow for discontinuous
jumps in stock prices or stochastic interest rates) or local volatility models. Nonetheless, our
results show that the actual pricing model provides results similar to those for the Heston model.
Based on the Heston model, we further analyze the structure of issuer margins. In addition
to evidence supporting the life cycle hypothesis for bonus certicates, we also nd evidence
that margins are a decreasing function of the certicates moneyness. We can therefore deduce
that issuers exploit their leeway in charging a higher margin when the value of the certicate
is less transparent. This higher margin also compensates issuers for higher model risk in these
situations. Concerning the average level of the margins, they are relatively large (amounting to
4.9% for Goldman Sachs and 2.1% to 3.1% for other issuers), compared to margins in recent
studies of retail derivatives with embedded plain-vanilla options. These gures become less
pronounced in light of the rather long lifetime of bonus certicates. According to the moneyness
eect, annualized margins show strong variations over the course of time, as average moneyness
varies with the underlying level. While average annualized margins range between 1% and 2%
for 2007, with the stock market decline in 2008, they increase to 3% to 5%. The overall average
amounts to 2.56%, which is however fairly large.
26
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29
0.00
0.05
0.10
0.15
0.20
0. 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5
Underlying price
O
p
t
i
o
n

a
l
u
e
Black,Scholes ,Strike olatility,
Black,Scholes ,At-the-money olatility,
Black,Scholes ,Barrier olatility,
leston
Exhibit 1. Black-Scholes and Heston model values of a down-and-out put option with strike price 1 = 1, barrier
level 1 = 0.6, and time to maturity T t = 1, for underlying prices between 0.65 and 1.5. Heston model values
are calculated with the parameters initial variance
0
= 0.02, long-run mean variance 0 = 0.05, mean-reversion
speed r = 1.5, volatility of volatility j = 0.6, and correlation coecient j = 0.6. The risk-free interest rate is
v = 0.04. Black-Scholes model values are obtained by using implied volatilities for plain-vanilla options (having
values consistent with the Heston model) with strike price equal to (i) the respective stock price (at-the-money),
(ii) the strike price of the barrier option, or, (iii) its barrier level.
30
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.0
0 0.1 0.2 0.3 0.4 0.5 0.6 0. 0.8
Volatility
O
p
t
i
o
n

a
l
u
e
Exhibit 2. Black-Scholes model value of a down-and-out put option with strike price 1 = 1, barrier level 1 = 0.6,
and time to maturity T t = 1, for a stock price o

= 1 and volatilities varying between 0 and 0.8.

31
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32
0.00
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0.20
0.25
0.30
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0.40
11,06 02,0 05,0 08,0 11,0 02,08 05,08 08,08
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out-o-the-money
at-the-money
in-the-money
Exhibit 4. Implied volatility for out-of-the-money (80% of the at-the-money level: solid line), at-the-money
(dotted line) and in-the-money (120% of the at-the-money level: dashed line) DAX options during the period
November 2006 through August 2008.
33
Black-Scholes Heston Heston ann.
Issuer atm strike barrier
BNP Paribas 1.43% 1.19% 3.68% 3.13% 2.85%
(2.66%) (2.85%) (3.50%) (2.12%) (2.72%)
Commerzbank 0.97% 0.24% 1.69% 2.09% 1.98%
(1.68%) (1.47%) (2.01%) (1.42%) (2.31%)
Goldman Sachs 2.46% 1.20% 3.78% 4.85% 2.48%
(3.10%) (3.14%) (3.49%) (2.82%) (1.60%)
Sal. Oppenheim 0.01% 3.27% 3.30% 2.94% 2.51%
(2.30%) (2.82%) (3.07%) (1.46%) (1.33%)
Societe Generale 0.53% 2.57% 3.71% 2.94% 3.50%
(2.32%) (2.43%) (3.23%) (1.32%) (2.41%)
Total 1.47% 0.43% 3.32% 3.55% 2.56%
(2.77%) (3.18%) (3.29%) (2.44%) (2.12%)
Exhibit 5. Average margins, i.e., relative dierences between retail prices and model values, by issuer. Black-
Scholes model values are calculated with at-the-money volatility (atm), strike volatility (strike) and barrier
volatility (barrier). For the Heston model, the last column displays the annualized margin, that is, the average
margin divided by the remaining time to maturity. Standard deviations are reported in parentheses.
34
BS (atm) BS (strike) BS (barrier) Heston
All Issuers ( = 1, 057)
Constant 0.0207*** 0.0307*** 0.0138*** 0.0138***
(0.0029) (0.0027) (0.0028) (0.0025)
Lifetime +0.0139*** +0.0175*** +0.0102*** +0.0157***
(0.0008) (0.0008) (0.0039) (0.0007)
Moneyness 0.0569*** +0.0670*** 0.1398*** 0.0617***
(0.0067) (0.0062) (0.00569 (0.0043)
Time +0.0043* +0.0051* +0.0107 +0.0145
(0.0021) (0.0020) (0.0023) (0.0018)
1
2
0.3449 0.4071 0.6299 0.6566
:
1c-
0.0254 0.0261 0.0205 0.0151
BNP Paribas ( = 323)
Constant 0.0116 0.0262*** +0.0002 0.0002
(0.0059) (0.0050) (0.0045) (0.0036)
Lifetime +0.0085*** +0.0114*** +0.0022* +0.0093***
(0.0013) (0.0014) (0.0010) (0.0007)
Moneyness 0.0656*** +0.0409*** 0.1256*** 0.0823***
(0.0113) (0.0076) (0.0102) (0.0071)
Time +0.0002 0.0005 +0.0124** +0.0062*
(0.0049) (0.0039) (0.0039) (0.0032)
1
2
0.2418 0.2625 0.6270 0.6654
:
1c-
0.0256 0.0247 0.0191 0.0127
Commerzbank ( = 161)
Constant 0.0007 0.0022 0.0008 +0.0025
(0.0025) (0.0030) (0.0021) (0.0015)
Lifetime +0.0035** +0.0057*** +0.0030** +0.0056***
(0.0012) (0.0013) (0.0010) (0.0009)
Moneyness 0.0776*** 0.0174 0.1206*** 0.0671***
(0.0096) (0.0146) (0.0109) (0.0062)
Time +0.0051* 0.0014 +0.0114*** +0.0105***
(0.0023) (0.0029) (0.0020) (0.0012)
1
2
0.4844 0.0760 0.8188 0.7474
:
1c-
0.0129 0.0194 0.0094 0.0077
Exhibit 6. Results of regressions of margins for the four models with respect to the remaining lifetime to maturity,
the calendar time, and the moneyness. . denotes the number of observations, and

is the standard deviation

of the regression residuals. Numbers in brackets are the standard errors, which are estimated following a robust
procedure taking heteroscedasticity into account (White, 1980). Signicance at the 5% level is indicated with *, at
the 1% level with **, and at the 0.1% level with ***.
35
BS (atm) BS (strike) BS (barrier) Heston
Goldman Sachs ( = 369)
Constant 0.0294*** 0.0401*** 0.0272*** 0.0250***
(0.0049) (0.0039) (0.0047) (0.0041)
Lifetime +0.0174*** +0.0211*** +0.0156*** +0.0192***
(0.0012) (0.0010) (0.0012) (0.0010)
Moneyness 0.0730*** +0.0406*** 0.1515*** 0.0626***
(0.0137) (0.0098) (0.0134) (0.0078)
Time +0.0083* +0.0118*** +0.0129*** +0.0237***
(0.0033) (0.0026) (0.0037) (0.0028)
1
2
0.4899 0.5860 0.6607 0.7265
:
1c-
0.0263 0.0225 0.0225 0.0162
Sal. Oppenheim ( = 117)
Constant 0.0269** 0.0312*** 0.0185* 0.0068
(0.0101) (0.0051) (0.0072) (0.0037)
Lifetime +0.0098*** +0.0166*** +0.0038* +0.0168***
(0.0028) (0.0019) (0.0017) (0.0015)
Moneyness 0.0733** +0.1686*** 0.1999*** 0.0379***
(0.0232) (0.0143) (0.0196) (0.0105)
Time 0.0019 +0.0084 +0.0036 +0.0069*
(0.0074) (0.0045) (0.0052) (0.0030)
1
2
0.2604 0.6774 0.7614 0.5562
:
1c-
0.0215 0.0158 0.0161 0.0124
Societe Generale ( = 87)
Constant +0.0067 +0.0014 0.0076 0.0002
(0.0145) (0.0105) (0.0111) (0.0045)
Lifetime 0.0050 0.0058 +0.0032 +0.0139***
(0.0062) (0.0048) (0.0049) (0.0019)
Moneyness 0.1168*** +0.0678** 0.2146*** 0.0733***
(0.0331) (0.0221) (0.0293) (0.0093)
Time 0.0167 0.0048 0.0028 +0.0004
(0.0102) (0.0066) (0.0087) (0.0035)
1
2
0.2227 0.1971 0.7050 0.6482
:
1c-
0.0236 0.0193 0.0177 0.0075
Exhibit 6. (continued)
36
0
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Exhibit 7. Average monthly annualized Heston margin and average moneyness over the sample period. The left
vertical axis refers to margins, shown as squares with error bars equal to one standard deviation. The right vertical
axis refers to moneyness, shown as a solid line. Averages are taken over all observations of all issuers per month.
The two time series are negatively correlated with a coecient of 0.95.
37
BS (atm) BS (strike) BS (barrier)
All Issuers ( = 1, 057)
Constant 0.0127*** 0.0135*** 0.0133***
(0.0024) (0.0024) (0.0024)
Model Dierence +1.0161*** +0.9533*** +0.8665***
(0.0276) (0.0229) (0.0326)
Lifetime +0.0153*** +0.0153*** +0.0147***
(0.0007) (0.0006) (0.0007)
Moneyness 0.0614*** 0.0489*** 0.0747***
(0.0043) (0.0054) (0.0053)
Time +0.0138*** +0.0132*** +0.0136***
(0.0017) (0.0016) (0.0018)
1
2
0.7804 0.8301 0.8058
BNP Paribas ( = 323)
Constant +0.0011 0.0034 +0.0001
(0.0035) (0.0033) (0.0036)
Model Dierence +1.1171*** +0.8951*** +0.9858***
(0.0374) (0.0339) (0.0500)
Lifetime +0.0091*** +0.0093*** +0.0089***
(0.0007) (0.0007) (0.0009)
Moneyness 0.0827*** 0.0624*** 0.0846***
(0.0068) (0.0080) (0.0076)
Time +0.0068* +0.0056* +0.0064*
(0.0031) (0.0027) (0.0032)
1
2
0.8221 0.8441 0.8313
Commerzbank ( = 161)
Constant +0.0029 +0.0034* +0.0016
(0.0015) (0.0015) (0.0016)
Model Dierence +1.1012*** +1.1578*** +0.7241***
(0.0869) (0.0504) (0.1032)
Lifetime +0.0057*** +0.0055*** +0.0048***
(0.0008) (0.0008) (0.0009)
Moneyness 0.0659*** 0.0720*** 0.0827***
(0.0060) (0.0060) (0.0088)
Time +0.0108*** +0.0119*** +0.0108***
(0.0014) (0.0014) (0.0013)
1
2
0.8238 0.8701 0.8939
Exhibit 8. Results of regressions of margins for the three Black-Scholes variants with respect to the relative
dierence of the Heston model value and the respective Black-Scholes model variant, the lifetime, the calendar
time, and the moneyness. . denotes the number of observations. Numbers in brackets are the standard errors,
which are estimated following a robust procedure taking heteroscedasticity into account (White, 1980). Signicance
at the 5% level is indicated with *, at the 1% level with **, and at the 0.1% level with ***.
38
BS (atm) BS (strike) BS (barrier)
Goldman Sachs ( = 369)
Constant 0.0232*** 0.0258*** 0.0244***
(0.0039) (0.0036) (0.0040)
Model Dierence +1.0129*** +0.8153*** +0.9484***
(0.0438) (0.0414) (0.0576)
Lifetime +0.0186*** +0.0190*** +0.0186***
(0.0009) (0.0008) (0.0010)
Moneyness 0.0630*** 0.0374*** 0.0710***
(0.0078) (0.0092) (0.0098)
Time +0.0222*** +0.0200*** +0.0223***
(0.0026) (0.0022) (0.0028)
1
2
0.8189 0.8363 0.8265
Sal. Oppenheim ( = 117)
Constant 0.0101* 0.0131*** 0.0105*
(0.0044) (0.0037) (0.0044)
Model Dierence +0.8179*** +0.7065*** +0.6922***
(0.0602) (0.0745) (0.0895)
Lifetime +0.0150*** +0.0160*** +0.0125***
(0.0015) (0.0012) (0.0017)
Moneyness 0.0443*** +0.0293* 0.0911***
(0.0110) (0.0137) (0.0208)
Time +0.0048 +0.0072** +0.0057
(0.0033) (0.0025) (0.0032)
1
2
0.8141 0.8908 0.8842
Societe Generale ( = 87)
Constant +0.0005 +0.0008 0.0006
(0.0045) (0.0043) (0.0045)
Model Dierence +0.9881*** +0.9204*** +0.9717***
(0.0344) (0.0395) (0.0596)
Lifetime +0.0129*** +0.0113*** +0.0133***
(0.0021) (0.0019) (0.0020)
Moneyness 0.0744*** 0.0549*** 0.0822***
(0.0097) (0.0102) (0.0131)
Time 0.0004 +0.0000 +0.0000
(0.0036) (0.0032) (0.0037)
1
2
0.9245 0.9030 0.9448
Exhibit 8. (continued)
39