Volatility models specifics

This section covers the volatility calculations and interpolation of volatilities for Orc volatility
models.

Wing model

Parameters for the Wing model

Column Description
Expiry Expiry date.
Days Days remaining until expiry.
ATM fwd. The current ATM forward (F) value used for the volatility calculation.
For an option, a theoretical forward can be calculated (see column picker for more
information on theoretical forward). The ATM forward for an expiry date in Volatility
manager is the theoretical forward of the options in the expiry date, assuming that the
value is the same for all options.
ssr The skew swimmingness rate (ssr) is a skew setting that defines the volatility curve
movement along the strike scale with respect to changes in the ATM forward value. It
also affects current volatility and current slope calculations.
If you set the ssr to 100% (completely swimming skew) for the expiry date on the
Volatility Manager window, the calculations are based on the synthetic forward price of
the contracts for the expiry date using all the relevant parameters of the options. The
synthetic is displayed above the skew graph on the Volatility Manager window as the
at-the-money (ATM) strike, followed by the ATM volatility in brackets ([XX.XX%]). This
price is referred to as the ATM strike price of the options. For more information about
ATM, see “Defining the volatility skew” on page 22-5.
To get a well-defined ATM strike for an expiry date, parameters such as base contract,
yield curve, and underlying rate need to be the same for all contracts in the expiry.
When using ssr=0 (fixed skew) for the expiry date, the reference price value is used
instead of the ATM strike price. The skew is, therefore, fixed until the reference price
(or other skew parameters) change. Hence, you must set the reference price on the
Volatility Manager window to use fixed skew. See “Skew parameters table and points”
on page 22-9.
When using a value for ssr between 0 and 100% (partially swimming skew), both the
ATM strike price and the reference price are used in the calculation of the central skew
point.
See “Skew parameters table and points” on page 22-9 for information on how to
specify the ssr value. For a description of the calculations of actual volatility used for a
contract from the volatility surface, see “Wing model” on page 22-36.
Vol. ref The volatility reference (vr) is a skew setting that shows the constant part of the current
volatility at central skew point.
VCR The volatility change rate (VCR) is a skew setting that defines dependency of the
current volatility at central skew point on changes in the ATM forward value.
The volatility change rate (VCR) indicates an increase in the volatility when the ATM
forward (F) moves down in relation to the reference price (Ref.price). Note that VCR is
multiplied by the ssr before being applied. Therefore, the fixed volatility curve (SSR=0)
is not affected by the volatility change rate. See “Wing model” on page 22-36.
Example: A VCR value of 0.2 indicates that the volatility will increase/decrease by 0.2
percentage units per percentage that the ATM is decreased/increased in relation to the
reference price (Ref.price).
The same is true for SCR, which in turn affects the slope value in the same way.
Note: VCR and SCR can be excluded when running a portfolio report. You can also
choose to omit these values on portfolio windows and trading pages. See “Simulation”
on page 24-1.

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Column Description
Curr. vol. The current volatility (vc) at central skew point (Ref is reference price).
vc = vr - VCR * ssr * (F- Ref) / Ref
Slope ref The slope reference (sr) is a skew setting that shows the constant part of the current
slope at central skew point.
SCR The slope change rate (SCR) is a skew setting that defines dependency of the current
slope at central skew point on changes in the ATM forward value.
Curr. slope The current slope (sc) at central skew point (Ref is reference price).
sc = sr - SCR * ssr * (F- Ref) / Ref
Put curv. The put curvature (Pc) is a skew setting that shows the amount of bending of the
volatility curve on the put wing between down cutoff and central skew point.
Call curv. The call curvature (Cc) is a skew setting that shows the amount of bending of the
volatility curve on the call wing between central skew point and up cutoff.
Down cut off The down cutoff (du) is a skew setting that defines a transition point between the put
wing and the down smoothing range. This point corresponds to X=F*exp(Dcut).
Up cut off The up cutoff (uc) is a skew setting that defines a transition point between the call wing
and the up smoothing range. This point corresponds to X=F*exp(Ucut).
Down sm. The down smoothing range (dsm) is a skew setting that defines a length of the range
on the strike scale where the volatility curve gradually changes from down cutoff to
constant volatility level. The length of this range is defined in relation to the length of
the put wing. Default value is 0.5.
Up sm. The up smoothing range (usm) is a skew setting that defines a length of the range on
the strike scale where the volatility curve gradually changes from up cutoff to constant
volatility level. The length of this range is defined in relation to the length of the call
wing. Default value is 0.5.
Ref. price The reference price (Ref) is a skew setting that gives a reference value for relative
changes in the current forward in order to define the effect VCR and SCR has on current
volatility and slope. In addition, Ref is used for the central skew point calculation (F)
when ssr is less than 100%.

Volatility surface
The volatility surface in Orc is defined as a set of volatility skews. Each volatility skew is
assigned to a certain expiration date. Depending on the preference setting, these expiration
dates can be set as fixed or can shift with time, keeping the interval to expiration date constant
for each of the volatility skews. This setting is selected on the Preferences panel and is per
client.
Each volatility skew is defined by its skew settings and current forward price (F) for its
expiration date..
The skew swimmingness rate (ssr) defines the skew movement along the strike scale with
respect to changes in the ATM forward price. The 0% ssr makes the skew fixed, that is, not
sensitive to movements in market prices. When ssr is set to 100%, the central skew point
follows the ATM forward price. The ssr setting can be defined for each expiration date
independently.

Volatility skew settings

The volatility skew settings in Orc are a set of the following parameters. The table lists the
different parameters, the abbreviations used to refer to them both in the formulas in this

Volatility models specifics 22-37(of 50)

 chapter (Formula abbreviation) and on the volatility skew settings pane of Volatility Manager
(Vol. Man. abbreviation), and the valid value range for each parameter (Valid range).

Volatility skew setting Formula Vol. Man. Valid range

abbreviation abbreviation
Reference price Ref Ref.price >0
Put curvature pc Put curv.
Call curvature cc Call curv.
Down cutoff dc Down cutoff <0
Up cutoff uc Up cutoff >0
Volatility change rate vcr VCR
Slope change rate scr SCR
Skew swimmingness rate ssr SSR 0%-100%
Down smoothing range dsm Down Sm. >0
Up smoothing range usm Up Sm. >0
ATM forward Atm ATM /ATM
fwd
Reference (forward) price Ref Ref. price
Derived values
Current volatility vc Curr. vol. 0.05%-400%
Current slope sc Curr. slope

Note The calculated volatility is limited to the same range as the volatility reference parameter.
These parameters together with the "current forward price" (F) define the volatility curve for a
given expiration date. The volatility curve consists of six parts: two parabolic wings with a
beginning at the central point, two smoothing ranges behind each wing, and two constant levels
on each side of the skew.
The calculation of the volatility for a given strike can be described as follows.
Firstly, we calculate the current forward price as follows:
• If SSR = 100, F equals the ATM forward.
• If SSR = 0, F equals the reference price for the volatility entry.
• If SSR is somewhere
-ssr
in% 1between,
---&
– -ssr i.e. it is a fraction of swimming skew,
--- # $
then F = ! Atm " 100 ' ! Ref " 100
where SSR is any number between 0% and 100% and a zero value corresponds to a fixed
skew and 100% corresponds to a swimming skew.
Next, we calculate the current volatility and the current slope at the central skew point. These
values may differ from the reference volatility and the reference slope is SSR, SCR and VCR
are set.
• Current volatility,
vcr ' ssr ' ! Atm – Ref "
vc = % vr – ------------------------------ &
# Ref $

• Current slope,
scr ' ssr ' ! Atm – Ref "
sc = % sr – ------------------------------&
# Ref $

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 Thirdly, we introduce an auxiliary variable, the converted strike x . When using the Wing model,
the converted strike is x = ln ! X ( F " . When using the Wing Eurofuture model, it is set to
x = ln ! ! 100 – F " ( ! 100 – X " " where X is the strike.
Volatility at this converted strike, vol(x) is then calculated as follows:
Between the cut-offs it is essentially a parabola with possibly differing curvatures on each side:
2
uc * x ) 0: vol ! x " = vc + sc ' x + pc ' x
2
0 * x ) uc: vol ! x " = vc + sc ' x + cc ' x
The smoothing ranges are dc ! 1 + dsm " * x ) dc and uc * x ) uc ! 1 + usm " , respectively. Here the
volatility function interpolates between the before mentioned parabola and a constant value
outside the interval dc ! 1 + dsm " * x * uc ! 1 + usm " .
Explicitly this means:
dc ! 1 + dsm " * x ) dc:
---'--dc
sc ---- + ! 1 + 1 ( dsm " ' ! 2 ' pc ' dc + sc " ' x – % -- ----------& ' x
--- + --------sc
pc
2 2
vol ! x " = vc – ! 1 + 1 ( dsm " ' pc ' dc – ---
! 2 ' dsm " # dsm ! 2 ' dc ' dsm "$

dc ! 1 + dsm " + x:
2
vol ! x " = vc + dc ! 2 + dsm " ! sc ( 2 " + ! 1 + dsm "pc ' dc

uc ! 1 + usm " , x + uc:

----'--uc
vol ! x " = vc – ! 1 + 1 ( usm " ' cc ' uc – --sc ---- + ! 1 + 1 ( usm " ' ! 2 ' cc ' uc + sc " ' x – % --cc ----------& ' x
--- + --------sc
2 2
! 2 ' usm " # usm ! 2 ' uc ' usm "$

uc ! 1 + usm " * x:
2
vol ! x " = vc + uc ! 2 + usm " ! sc ( 2 " + ! 1 + usm "cc ' uc

Inter- and extrapolation of the skew settings

The volatility skew settings are interpolated between expiration dates with the assigned
volatility skews. Most of the skew settings are interpolated linearly with respect to the time
interval until maturity between the closest expiration dates with the assigned skew settings.
For T1 < TX < T2
S(TX) = ( S(T1) * ( T2 - TX ) + S(T2) * ( TX - T1 )) / ( T2 - T1 )
TX - number of days until expiration date without assigned skew settings
T1 - number of days until the closest expiration date with assigned skew settings < TX
T2 - number of days until the closest expiration date with assigned skew settings > TX
S(T) - single skew setting for the given maturity time T
The skew settings assigned to the closest expiration date are used for extrapolation of the
volatility surface for expiration dates outside the interval defined in the surface.
Example We have an option with 30 days to expiry, strike price ( X ) equal to 110 and the theoretical ATM
strike ( F ) equal to 105. Given the set skew parameters below,

Days Vol Slope pc cc dc uc

10 22 -1 2 1 -0.5 0.5
50 21 -0.5 1 0.5 -0.5 0.5

the volatility would be calculated in the following manner:

u = ! 30 – 10 " ( ! 50 – 10 " = 0,5

vc = 22 ! 1 – u " + 21u = 21,5

Volatility models specifics 22-39(of 50)

 sc = ! – 1 " ' 0,5 + ! – 0,5 " ' 0,5 = – 0,75

pc = 2 ' 0,5 + 1 ' 0,5 = 1,5

cc = 1 ' 0,5 + 0,5 ' 0,5 = 0,75

dc = ! – 0,5 " ' 0,5 + ! – 0,5 " ' 0,5 = – 0,5

uc = 0,5 ' 0,5 + 0,5 ' 0,5 = 0,5

x = ln ! X ( F " = ln ! 110 ( 105 " - 0,05

Thus the volatility becomes

vol ! 0,05 " = 21,5 + ! – 0,75 ' 0,05 " + ! 0,75 ' 0,05 2 " - 21,4

Time weighted wing model

The time weighted wing differs from the wing model regarding the converted strike x . When
using the Wing model, the converted strike is x = ln ! X ( F " . The transformed strike for the time
weighted wing model is x = In ! X ( F " ( ! T " where T is the time in years to expiry, floored at one
day.
See “Volatility skew settings” on page 22-37 for more information.

Cubic spline (static) model

The Cubic spline (static) model is based on strike prices and implied volatilities and will produce
a static surface, i.e. it will not change with the underlying price. This model has one parameter,
Nbr of points that controls number of spline points.

Fitting
From a users point of view there is no difference between fitting and interpolation in this model.
The actual curve fitting in this model only amounts to saving the strike prices and the mean
values of all implied volatilities provided to the models fitting algorithm. When fitting is done
from the Volatility Manager or from a Trading window, the points that are to be stored on the
curve are calculated and a curve is calculated using the cubic spline interpolation.

Interpolation
Interpolation is performed with cubic spline polynomials. Given the strike prices X 0/ X 1/ X 2/ ./ X N
and the volatilities v0/ v1/ v 2/ ./ vN at these strike prices, the curve is approximated by cubic
polynomials on each interval (X i/ X i + 1 0 , i.e. for a strike price X 1 (X i/ X i + 1 0 the volatility at X is
give by
2 3
P i ! X " = a i + b i ! X – X i " + c i ! X – X i " + d i ! X – Xi "

The coefficients ai/ bi/ ci and di/ i = 0/ 1/ 2/ ./ N – 1 , are computed requiring that the resulting
polynomials satisfies C2 regularity at the internal nodes, i.e. that for each i = 0/ 1/ 2/ ./ N – 2
Pi ! Xi + 1 " = Pi + 1 ! Xi + 1 "
P i 2 ! X i + 1 " = P2 i + 1 ! X i + 1 "
P3 i ! X i + 1 " = P3i + 1 ! X i + 1 "

Moreover, at all nodes X i , i = 0/ 1/ 2/ ./ N – 1 , it holds that P i ! X i " = v i and also that

P N – 1 ! XN " = v N . At the endpoints we specify a so-called natural spline condition, P3 0 ! X 0 " = 0
and P3 N – 1 ! X N " = 0 . For a more detailed description of the cubic spline interpolation used in this
model, see the Orc Quantitative Guide.

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