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The Vanna-Volga method for implied volatilities

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 The Vanna-Volga method for implied volatilities:
tractability and robustness
∗
Antonio Castagna Fabio Mercurio

Abstract
In this article, we describe the Vanna-Volga method, a popular approach for con-
structing implied-volatility curves in the FX option market. We give it both theoret-
ical and practical support by showing its tractability and robustness. A comparison
with other known interpolation function is also provided. Efficient approximations
for the related implied volatility are also derived.

1 Introduction
The Vanna-Volga (VV) method is a known empirical procedure that can be used to infer
an implied-volatility smile from three available quotes for a given maturity.1 It is based on
the construction of locally-replicating portfolios whose associate hedging costs are added
to corresponding Black-Scholes prices so as to produce smile-consistent values. Besides
being intuitive and easy to implement, this procedure has a clear financial interpretation,
which further supports its use in practice.
The VV method is commonly adopted in foreign exchange (FX) option markets, where
three main volatility quotes are typically available for a given market maturity: the Delta-
neutral straddle, referred to as the at-the-money (ATM), the risk reversal (RR) for 25∆
call and put and the (vega-weighted) butterfly (VWB) with 25∆ wings.2 The application
of VV allows to derive implied volatilities for any option’s delta, and in particular for those
outside the basic range set by the 25∆ put and call quotes.
In the financial literature, the VV approach has been introduced by Lipton and McGhee
(2002), who compare different approaches for the pricing of double-no-touch options, and
by Wystup (2003) who describes its application to the valuation of one-touch options.
However, their analyses are rather informal and mostly based on numerical examples. In
∗
We thank three anonymous referees for their comments and helpful suggestions.
1
The terms Vanna and Volga are commonly used by practitioners to denote the partial derivatives
∂Vega ∂Vega
∂Spot and ∂Vol of an option’s Vega with respect to the underlying asset and its volatility, respectively.
The reason for naming the procedure this way will be clear below.
2
We drop the “%” sign after the level of the ∆, in accordance to the market jargon. Therefore, a 25∆
call is a call whose Delta is 0.25. Analogously, a 25∆ put is one whose Delta is -0.25.

1
this article, instead, we will review the VV procedure in more detail and derive some
important results concerning the tractability of the method and its robustness.
We start by describing the replication argument the VV procedure is based on and
derive closed-form formulas for the weights in the hedging portfolio so as to render the smile
construction more explicit. We then show that the VV price functional satisfies typical
no-arbitrage conditions and test the robustness of the resulting smile by showing that: i)
changing consistently the three initial pairs of strike and volatility produces eventually the
same implied volatility curve; ii) the VV method, if readapted to price European-style
claims, is consistent with static-replication arguments. We will finally derive first- and
second-order approximations for the implied volatilities induced by the VV option price.
Since the VV method provides an efficient tool for interpolating or extrapolating implied
volatilities, we also compare it with other popular functional form, like that of Malz (1997)
and that of Hagan et al. (2002).
All the proofs of the propositions in this article are omitted for brevity. They can be
found, however, in Castagna and Mercurio (2005).

2 The VV method: the replicating portfolio

We consider an FX option market where, for a given maturity T , three basic options are
quoted: the 25∆ put, the ATM and the 25∆ call. We denote the corresponding strikes by
Ki , i = 1, 2, 3, K1 < K2 < K3 , and set K := {K1 , K2 , K3 }.3 The market implied volatility
associated to Ki is denoted by σi , i = 1, 2, 3.
The VV method serves the purpose of defining an implied-volatility smile that is con-
sistent with the basic volatilities σi . The rationale behind it stems from a replication
argument in a flat-smile world where the constant level of implied volatility varies stochas-
tically over time. This argument is presented hereafter, where for simplicity we consider
the same type of options, namely calls.
It is well known that in the Black and Scholes (BS) model, the payoff of a European call
with maturity T and strike K can be replicated by a dynamic ∆-hedging strategy, whose
value (comprehensive of the bank account part) matches, at every time t, the option price
C BS (t; K) given by
µ ¶ µ St ¶
−rf τ ln SKt + (rd − rf + 12 σ 2 )τ ln K + (rd − rf − 12 σ 2 )τ
−rd τ
C (t; K) = St e
BS
Φ √ − Ke Φ √
σ τ σ τ
(1)
d f
where St denotes the exchange rate at time t, τ := T − t, r and r denote, respectively,
the domestic and foreign risk-free rates and σ is the constant BS implied volatility.4 In real
3
For the exact definition of strikes K1 , K2 and K3 we refer to Bisesti et al. (2005), where a thorough
description of the main quotes in an FX option market is also provided.
4
The option price when the underlying asset is an exchange rate was in fact derived by Garman and
Kohlhagen (1983). Since their formula follows from the BS assumption, we prefer to state we are using
the BS model, also because the VV method can in principle be applied to other underlyings.

2
financial markets, however, volatility is stochastic and traders hedge the associated risk by
constructing portfolios that are Vega-neutral in a BS (flat-smile) world.
Maintaining the assumption of flat but stochastic implied volatilities, the presence of
three basic options in the market even makes it possible to build a portfolio that zeros
partial derivatives up to the second order. In fact, denoting respectively by ∆t and xi the
units of underlying asset and options with strikes Ki held at time t and setting CiBS (t) =
C BS (t; Ki ), under diffusion dynamics both for St and σ = σt , we have by Ito’s lemma
3
X
dC (t; K) − ∆t dSt −
BS
xi dCiBS (t)
i=1
· 3
X ¸ · BS X 3 ¸
∂C BS (t; K) ∂CiBS (t) ∂C (t; K) ∂CiBS (t)
= − xi dt + − ∆t − xi dSt
∂t i=1
∂t ∂S i=1
∂S
· BS 3 ¸ · 3 ¸
∂C (t; K) X ∂CiBS (t) 1 ∂ 2 C BS (t; K) X ∂ 2 CiBS (t)
+ − xi dσt + 2
− xi 2
(dSt )2
∂σ i=1
∂σ 2 ∂S i=1
∂S
· 2 BS 3 ¸ · 3 ¸
1 ∂ C (t; K) X ∂ 2 CiBS (t) 2 ∂ 2 C BS (t; K) X ∂ 2 CiBS (t)
+ − xi (dσt ) + − xi dSt dσt .
2 ∂σ 2 i=1
∂σ 2 ∂S∂σ i=1
∂S∂σ
(2)

Choosing ∆t and xi so as to zero the coefficients of dSt , dσt , (dσt )2 and dSt dσt ,5 the
portfolio made of a long position in the call with strike K, short positions in xi calls with
strike Ki and short the amount ∆t of the underlying, is locally riskless at time t, in that
no stochastic terms are involved in its differential:6

3
X · 3
X ¸
d
dC (t; K) − ∆t dSt −
BS
xi dCi (t) = r C (t; K) − ∆t St −
BS BS
xi Ci (t) dt
BS
(3)
i=1 i=1

Therefore, when volatility is stochastic and options are valued with the BS formula, we
can still have a (locally) perfect hedge, provided that we hold suitable amounts of three
more options to rule out the model risk (the hedging strategy is irrespective of the true
asset and volatility dynamics, under the assumption of no jumps).

Remark 2.1. The validity of the previous replication argument may be questioned because
no stochastic-volatility model can produce implied volatilities that are flat and stochastic
at the same time. The simultaneous presence of these features, though inconsistent from
a theoretical point of view, can however be justified on an empirical ground. In fact, the
practical advantages of the BS paradigm are so clear that many FX option traders run
5
The coefficient of (dSt )2 will be zeroed accordingly, due to the relation linking an option’s Gamma
and Vega in the BS world.
6
We also use the BS P.D.E.

3
their books by revaluating and hedging according to a BS flat-smile model, with the ATM
volatility being continuously updated to the actual market level.7
The first step in the VV procedure is the construction of the above hedging portfolio,
whose weights xi are explicitly computed in the following section.

3 Computing the VV weights

We assume hereafter that the constant BS volatility is the ATM one, thus setting σ = σ2 (=
σAT M ). We also assume that t = 0, dropping accordingly the argument t in the call prices.
From equation (2), we have that the weights x1 = x1 (K), x2 = x2 (K) and x3 = x3 (K), for
which the resulting portfolio of European calls with maturity T and strikes K1 , K2 and
K3 has the same Vega, ∂Vega
∂Vol
and ∂Vega
∂Spot
as the call with strike K,8 can be found by solving
the following system:

X 3
∂C BS ∂C BS
(K) = xi (K) (Ki )
∂σ i=1
∂σ
X 3
∂ 2 C BS ∂ 2 C BS
(K) = x i (K) (Ki ) (4)
∂σ 2 i=1
∂σ 2

X 3
∂ 2 C BS ∂ 2 C BS
(K) = xi (K) (Ki )
∂σ∂S0 i=1
∂σ∂S 0

Denoting by V(K) the Vega of a European option with maturity T and strike K,
∂C BS f √
V(K) = (K) = S0 e−r T T ϕ(d1 (K))
∂σ
(5)
ln SK0 + (rd − rf + 12 σ 2 )T
d1 (K) = √
σ T
where ϕ(x) = Φ0 (x) is the normal density function, and calculating the second order
derivatives
∂ 2 C BS V(K)
2
(K) = d1 (K)d2 (K)
∂σ σ
∂ 2 C BS V(K)
(K) = − √ d2 (K)
∂σ∂S0 S0 σ T
√
d2 (K) = d1 (K) − σ T

we can prove the following.

7
“Continuously” typically means a daily or slightly more frequent update.
8
This explains the name assigned to the smile-construction procedure, given the meaning of the terms
Vanna and Volga.

4
Proposition 3.1. The system (4) admits always a unique solution, which is given by

V(K) ln KK2 ln KK3

x1 (K) = K2
V(K1 ) ln K1
ln K3
K1
K K
V(K) ln K1 ln K3
x2 (K) = K2 (6)
V(K2 ) ln K1
ln K3
K2
K K
V(K) ln K1 ln K2
x3 (K) = K3
V(K3 ) ln K1
ln K3
K2

In particular, if K = Kj then xi (K) = 1 for i = j and zero otherwise.

4 The VV option price

We can now proceed to the definition of an option price that is consistent with the market
prices of the basic options.
The above replication argument shows that a portfolio made of xi (K) units of the
option with strike Ki (and ∆0 units of the underlying asset) gives a local perfect hedge in
a BS world. The hedging strategy, however, has to be implemented at prevailing market
prices, which generates an extra cost with respect to the BS value of the options portfolio.
Such a cost is to be added to the BS price (1), with t = 0, to produce an arbitrage-free
price that is consistent with the quoted option prices C MKT (K1 ), C MKT (K2 ) and C MKT (K3 ).
In fact, in case of a short maturity, i.e. for a small T , equation (3) can be approximated
as
3
X
(ST − K)+ − C BS (K) − ∆0 [ST − S0 ] − xi [(ST − Ki )+ − C BS (Ki )]
i=1
· 3
X ¸
d
≈ r C (K) − ∆0 S0 −
BS
xi C (Ki ) T,
BS

i=1

so that setting
3
X
C(K) = C (K) +
BS
xi (K)[C MKT (Ki ) − C BS (Ki )], (7)
i=1

we have
3
X
+
(ST − K) ≈ C(K) + ∆0 [ST − S0 ] + xi [(ST − Ki )+ − C MKT (Ki )]
i=1
· 3
X ¸
d
+ r C(K) − ∆0 S0 − xi C MKT
(Ki ) T.
i=1

5
Therefore, when actual market prices are considered, the option payoff (ST − K)+ can still
be replicated by buying ∆0 units of the underlying asset and xi options with strike Ki
(investing the resulting cash at rate rd ), provided one starts from the initial endowment
C(K).
The quantity C(K) in (7) is thus defined as the VV option’s premium, implicitly
assuming that the replication error is also negligible for longer maturities. Such a premium
equals the BS price C BS (K) plus the cost difference of the hedging portfolio induced by the
market implied volatilities with respect to the constant volatility σ. Since we set σ = σ2 ,
the market volatility for strike K2 , (7) can be simplified to
C(K) = C BS (K) + x1 (K)[C MKT (K1 ) − C BS (K1 )] + x3 (K)[C MKT (K3 ) − C BS (K3 )].
Remark 4.1. Expressing the system (4) in the form b = Ax and setting c = (c1 , c2 , c3 )0 ,
where ci := C MKT (Ki ) − C BS (Ki ), and y = (y1 , y2 , y3 )0 := (A0 )−1 c, we can also write
∂C BS ∂ 2 C BS ∂ 2 C BS
C(K) = C BS (K) + y1 (K) + y2 (K) + y 3 (K).
∂σ ∂σ 2 ∂σ∂S0
The difference between the VV and BS prices can thus be interpreted as the sum of the
option’s Vega, ∂Vega
∂Vol
and ∂Vega
∂Spot
, weighted by their respective hedging cost y.9
Besides being quite intuitive, this representation has also the advantage that the weights
y are independent of the strike K and, as such, can be calculated once for all. However,
we prefer to stick to the definition (7), since it allows an easier derivation of our approxi-
mations below.
The VV option price has several interesting features that we analyze in the following.
When K = Kj , C(Kj ) = C MKT (Kj ), since xi (K) = 1 for i = j and zero otherwise.
Therefore, (7) defines a rule for either interpolating or extrapolating prices from the three
option quotes C MKT (K1 ), C MKT (K2 ) and C MKT (K3 ).
The option price C(K), as a function of the strike K, is twice differentiable and satisfies
the following (no-arbitrage) conditions:
fT
i) limK→0+ C(K) = S0 e−r and limK→+∞ C(K) = 0;
dC dT dC
ii) limK→0+ dK
(K) = −e−r and limK→+∞ K dK (K) = 0.
These properties, which are trivially satisfied by C BS (K), follow from the fact that, for
each i, both xi (K) and dxi (K)/dK go to zero for K → 0+ or K → +∞.
To avoid arbitrage opportunities, the option price C(K) should also be a convex func-
d2 C
tion of the strike K, i.e. dK 2 (K) > 0 for each K > 0. This property, which is not true in

general,10 holds however for typical market parameters, so that (7) leads indeed to prices
that are arbitrage-free in practice.
The VV implied-volatility curve K 7→ ς(K) can be obtained by inverting (7), for
each considered K, through the BS formula. An example of such a curve will be pro-
vided in Figure 1 below. Since, by construction, ς(Ki ) = σi , the function ς(K) yields an
interpolation-extrapolation tool for the market implied volatilities.
9
We thank one of the referees for suggesting us this alternative formulation.
10
One can actually find cases where the inequality is violated for some strike K.

6
5 Comparison with other interpolation rules
Contrary to other interpolation schemes proposed in the financial literature, the VV pricing
formula (7) has several advantages: i) it has a clear financial rationale supporting it,
based on the hedging argument leading to its definition, ii) it allows for an automatic
calibration to the main volatility data, being an explicit function of σ1 , σ2 , σ3 and iii) it
can be extended to any European-style derivative, see our second consistency result below.
To our knowledge, no other functional form enjoys the same features.
Compared, for example, with the second-order polynomial function (in ∆) proposed by
Malz (1997), the interpolation (7) is equally perfect-fitting the three points provided, but,
in accordance with typical market quotes, boosts the volatility value both for low and high
put Deltas. A graphical comparison, based on market data, between the two functional
forms is shown in Figure 1, where their difference at extreme strikes is clearly highlighted.
The interpolation (7) also yields a very good approximation of the smile induced, after
calibration to strikes Ki , by the most renowned stochastic-volatility models in the financial
literature, especially within the range [K1 , K3 ]. This is not surprising, since the three strikes
provide information on the second, third and fourth moments of the marginal distribution
of the underlying asset, so that models agreeing on these three points are likely to produce
very similar smiles. As a confirmation of this statement, in Figure 1, we also consider the
example of the SABR functional form of Hagan et al. (2002), which has become a standard
in the market as far as the modelling of implied volatilities is concerned. The SABR and
VV curves tend to agree quite well in the range set by the two 10∆ options (in the given
example they almost overlap), typically departing from each other only for illiquid strikes.
The advantage of using the VV interpolation is that no calibration procedure is involved,
since σ1 , σ2 , σ3 are direct inputs of formula (7).
In Figure 1 we compare the volatility smiles yielded by the VV price (7), the Malz (1997)
quadratic interpolation and the SABR functional form,11 plotting the respective implied
volatilities both against strikes and against put Deltas. The three graphs are obtained after
calibration to the three basic quotes σ1 , σ2 , σ3 , using the following EUR/USD data as of
1 July 2005 (provided by Bloomberg): T = 3M ,12 S0 = 1.205, σ1 = 9.79%, σ2 = 9.375%,
σ3 = 9.29%, K1 = 1.1720, K2 = 1.2115 and K3 = 1.2504, see also Tables 1 and 2.
Once the three functional forms are calibrated to the liquid quotes σ1 , σ2 , σ3 , one may
then compare their values at extreme strikes with the corresponding quotes possibly pro-
vided by brokers or market makers. To this end, in Figure 1, we also report the implied
volatilities of the 10∆ put and call options (resp. equal to 10.46% and 9.49%, again pro-
vided by Bloomberg) to show that the Malz (1997) quadratic function is typically not
consistent with the quotes for strikes outside the basic interval [K1 , K3 ].
11
We fix the SABR β parameter to 0.6. Other values of β produce, anyway, quite similar calibrated
volatilities.
12
For precision’s sake, on that date the 3-month expiry counted 94 days.

7
 0.125 0.125
Vanna−Volga Vanna−Volga
Malz Malz
SABR SABR
0.12 0.12

0.115 0.115

0.11 0.11

0.105 0.105

0.1 0.1

0.095 0.095

0.09 0.09
1.05 1.1 1.15 1.2 1.25 1.3 1.35 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Strike Put Delta

Figure 1: Implied volatilities, plotted both against strikes and against put Deltas (in abso-
lute value), calibrated to the three basic EUR/USD quotes (yellow points) and compared
with the 10∆ (put and call) volatilities (in orange). Market data kindly provided by
Bloomberg.

Expiry USD EUR

3M: 03/10/2005 0.9902752 0.9945049

Table 1: Discount factors as of July 1, 2005.

Delta Strike Volatility

25∆ Put 1.1720 9.79%
ATM 1.2115 9.375%
25∆ Call 1.2504 9.29%

Table 2: Strikes and volatilities corresponding to the three main Deltas, as of July 1, 2005.

6 Two consistency results for the VV price

We now state two important consistency results that hold for the option price (7) and that
give further support to the VV procedure.
The first result is as follows. One may wonder what happens if we apply the VV
curve construction method when starting from three other strikes whose associated prices
coincide with those coming from formula (7). Clearly, for the procedure to be robust, we
would want the two curves to exactly coincide. This is indeed the case.
In fact, consider a new set of strikes H := {H1 , H2 , H3 }, for which we set
3
X
H K
C (Hi ) = C (Hi ) = C (Hi ) + BS
xj (Hi )[C MKT (Kj ) − C BS (Kj )], (8)
j=1

8
where the superscripts H and K highlight the set of strikes the pricing procedure is based
on, and weights xj are obtained from K with formulas (6). For a generic strike K, denoting
by xi (K; H) the weights for K that are derived starting from the set H, the option price
associated to H is defined, analogously to (7), by
3
X
H
C (K) = C (K) +
BS
xj (K; H)[C H (Hj ) − C BS (Hj )],
j=1

where the second term in the sum is now not necessarily zero since H2 is in general different
than K2 . The following proposition states the desired consistency result.

Proposition 6.1. The call prices based on H coincide with those based on K, namely, for
each strike K,
C H (K) = C K (K) (9)

A second consistency result that can be proven for the option price (7) concerns the
pricing of European-style derivatives and their static replication. To this end, assume that
h(x) is a real function that is defined for x ∈ [0, ∞), is well behaved at infinity and is twice
differentiable. Given the simple claim with payoff h(ST ) at time T , we denote by V its
price at time 0, when taking into account the whole smile of the underlying at time T . By
Carr and Madan (1998), we have:
Z +∞
−rd T −rf T 0
V =e h(0) + S0 e h (0) + h00 (K)C(K) dK.
0

The same reasoning adopted in Section 2 on the local hedge of the call with strike K can
also be applied to the general payoff h(ST ). We can thus construct a portfolio of European
calls with maturity T and strikes K1 , K2 and K3 , such that the portfolio has the same
Vega, ∂Vega
∂Vol
and ∂Vega
∂Spot
as the given derivative. Denoting by V BS the claim price under the
BS model, this is achieved by finding the corresponding portfolio weights xh1 , xh2 and xh3 ,
which always exist unique, see Proposition 3.1. We can then define a new (smile-consistent)
price for our derivative as
3
X
V̄ = V BS
+ xhi [C MKT (Ki ) − C BS (Ki )], (10)
i=1

which is the obvious generalization of (7). Our second consistency result is stated in the
following.

Proposition 6.2. The claim price that is consistent with the option prices (7) is equal
to the claim price that is obtained by adjusting its BS price by the cost difference of the
hedging portfolio when using market prices C MKT (Ki ) instead of the constant-volatility prices
C BS (Ki ). In formulas
V = V̄

9
 Therefore, if we calculate the hedging portfolio for the claim under flat volatility and
add to the BS claim price the cost difference of the hedging portfolio (market price minus
constant-volatility price), obtaining V̄ , we exactly retrieve the claim price V as obtained
through the risk-neutral density implied by the call option prices that are consistent with
the market smile.13
As an example of possible application of this result, Castagna and Mercurio (2005)
consider the specific case of a quanto option, showing that its pricing can be achieved by
using the three basic options only and not the virtually infinite range that is necessary
when using static replication arguments.

7 An approximation for implied volatilities

The specific expression of the VV option price, combined with our analytical formula (6)
for the weights, allows for the derivation of a straightforward approximation for the VV
implied volatility ς(K), by expanding both members of (7) at first order in σ = σ2 . We
obtain:
ln K2 ln KK3 ln KK1 ln KK3 ln KK1 ln KK2
ς(K) ≈ ς1 (K) := KK2 σ1 + K3 2
σ + K3 3
σ (11)
ln K1 ln K
K1
3
ln K2
K1
ln K2
ln K3
K1
ln K2

The implied volatility ς(K) can thus be approximated by a linear combination of the basic
volatilities σi , with combinators that sum up to one (as tedious but straightforward algebra
shows). It is also easily seen that the approximation is a quadratic function of ln K, so
that one can resort to a simple parabolic interpolation when log coordinates are used.
A graphical representation of the goodness of the approximation (11) is shown in Figure
2, where we use the same EUR/USD data as for Figure 1. The approximation (11) is
extremely accurate inside the interval [K1 , K3 ]. The wings, however, tend to be overvalued.
In fact, being the functional form quadratic in the log-strike, the no-arbitrage conditions
derived by Lee (2004) for the asymptotic value of implied volatilities are here violated. This
drawback is addressed by a second, more precise, approximation, which is asymptotically
constant at extreme strikes, and is obtained by expanding both members of (7) at second
order in σ = σ2 :
p
−σ2 + σ22 + d1 (K)d2 (K)(2σ2 D1 (K) + D2 (K))
ς(K) ≈ ς2 (K) := σ2 + , (12)
d1 (K)d2 (K)

where
D1 (K) := ς1 (K) − σ2
ln KK2 ln KK3 2
ln KK1 ln KK2
D2 (K) := K3 1
d (K )d
1 2 (K 1 )(σ1 − σ2 ) + K3 1
d (K3 )d2 (K3 )(σ3 − σ2 )2
ln K
K1
2
ln K1
ln K3
K1
ln K2

13
Different but equivalent expressions for such a density can be found in Castagna and Mercurio (2005)
and Beneder and Baker (2005).

10
 0.135 0.135
Vanna−Volga smile Vanna−Volga smile
1st order approximation 1st order approximation
2nd order approximation 2nd order approximation
0.13 0.13

0.125 0.125

0.12 0.12

0.115 0.115

0.11 0.11

0.105 0.105

0.1 0.1

0.095 0.095

0.09 0.09
1.05 1.1 1.15 1.2 1.25 1.3 1.35 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Strike Put Delta

Figure 2: EUR/USD implied volatilities and their approximations, plotted both against
strikes and against put Deltas (in absolute value).

As we can see from Figure 2, the approximation (12) is extremely accurate also in the
wings, even for extreme values of put Deltas. Its only drawback is that it may not be
defined due to the presence of a square-root term. The radicand, however, is positive in
most practical applications.

8 Conclusions
We have described the VV approach, a market empirical procedure to construct implied
volatility curves in the FX market. We have seen that the procedure leads to a smile-
consistent pricing formula for any European-style contingent claim. We have also compared
the VV option prices with those coming from other functional forms known in the financial
literature. We have then shown consistency results and proposed efficient approximations
for the VV implied volatilities.
The VV smile-construction procedure and the related pricing formula are rather general.
In fact, even though they have been developed for FX options, they can be applied in any
market where at least three reliable volatility quotes are available for a given maturity.
Actually, the application seems quite promising in other markets, where European-style
exotic payoffs are more common than in the FX market. Another possibility is given by the
interest-rate market, where CMS convexity adjustments can be calculated by combining
the VV price functional with the replication argument in Mercurio and Pallavicini (2006).
A last, unsolved issue concerns the valuation of path-dependent exotic options by means
of some generalization of the empirical procedure we have illustrated in this article. This
is, in general, a quite complex issue to deal with, also considering that the quoted implied
volatilities contain only information on marginal densities, which is of course not sufficient
for valuing path-dependent derivatives. For exotic claims, ad-hoc procedures are usually
employed. For instance, barrier option prices can be obtained by weighing the cost dif-

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ference of the “replicating” strategy by the (risk-neutral) probability of not crossing the
barrier before maturity (see Lipton and McGhee (2002) and Wystup (2003) for a descrip-
tion of the procedure for one-touch and double-no-touch options, respectively). However,
not only are such adjustments harder to justify theoretically than those in the plain vanilla
case, but, from the practical point of view, they can even have opposite sign with respect
to that implied in market prices (when very steep and convex smiles occur). We leave the
analysis of this issue to future research.

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