Goldman

Sachs Quantitative Strategies

Research Notes

August 1996
Trading and Hedging
Local Volatility

Iraj Kani
Emanuel Derman
Michael Kamal
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Copyright 1996 Goldman, Sachs & Co. All rights reserved.

This material is for your private information, and we are not soliciting any action based upon it. This report is not to
be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer
or solicitation would be illegal. Certain transactions, including those involving futures, options and high yield
securities, give rise to substantial risk and are not suitable for all investors. Opinions expressed are our present
opinions only. The material is based upon information that we consider reliable, but we do not represent that it is
accurate or complete, and it should not be relied upon as such. We, our affiliates, or persons involved in the
preparation or issuance of this material, may from time to time have long or short positions and buy or sell securities,
futures or options identical with or related to those mentioned herein.

This material has been issued by Goldman, Sachs & Co. and/or one of its affiliates and has been approved by
Goldman Sachs International, regulated by The Securities and Futures Authority, in connection with its distribution
in the United Kingdom and by Goldman Sachs Canada in connection with its distribution in Canada. This material is
distributed in Hong Kong by Goldman Sachs (Asia) L.L.C., and in Japan by Goldman Sachs (Japan) Ltd. This
material is not for distribution to private customers, as defined by the rules of The Securities and Futures Authority
in the United Kingdom, and any investments including any convertible bonds or derivatives mentioned in this
material will not be made available by us to any such private customer. Neither Goldman, Sachs & Co. nor its
representative in Seoul, Korea is licensed to engage in securities business in the Republic of Korea. Goldman Sachs
International or its affiliates may have acted upon or used this research prior to or immediately following its
publication. Foreign currency denominated securities are subject to fluctuations in exchange rates that could have an
adverse effect on the value or price of or income derived from the investment. Further information on any of the
securities mentioned in this material may be obtained upon request and for this purpose persons in Italy should
contact Goldman Sachs S.I.M. S.p.A. in Milan, or at its London branch office at 133 Fleet Street, and persons in Hong
Kong should contact Goldman Sachs Asia L.L.C. at 3 Garden Road. Unless governing law permits otherwise, you
must contact a Goldman Sachs entity in your home jurisdiction if you want to use our services in effecting a
transaction in the securities mentioned in this material.

Note: Options are not suitable for all investors. Please ensure that you have read and understood the
current options disclosure document before entering into any options transactions.
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

SUMMARY
This note outlines a methodology for hedging and trading
index volatilities.
In the bond world, forward rates are the arbitrage-free
interest rates at future times that can be locked in by
trading bonds today. Similarly, in the world of index
options, local volatilities are the arbitrage-free volatilities
at future times and market levels that can be locked in by
trading options today. The dependence of local volatility
on future time and index level is called the local volatility
surface, and is the analog of the forward yield curve. In
this paper we show how to hedge portfolios of index
options against changes in implied volatility by hedging
them against changes in future local volatility. This is
analogous to hedging bond portfolios against changes in
forward rates.

Eurodollar futures on interest rates are the best-suited

instrument for forward-rate hedging. Unfortunately,
there are no liquid futures on local index volatility. So, we
will define a volatility gadget, the volatility analog of a
Eurodollar futures contract. A gadget is a small portfolio
of standard index options that is sensitive to local index
volatility only at a definite future time and index level,
and, like a futures contract, has an initial price of zero.
We can create unique volatility gadgets for each future
time and index level. By buying or selling suitable quan-
tities of gadgets, corresponding to different future times
and market levels, we can hedge an index option portfolio
against any changes in future local volatility. This proce-
dure is theoretically costless. It can help remove
unwanted volatility risk, or help acquire desired volatil-
ity exposure, over any range of index levels and times
where we think future local volatility changes are likely
to occur.
________________________
Iraj Kani (212) 902-3561
Emanuel Derman (212) 902-0129
Michael Kamal (212) 357-3722

Editorial: We are grateful to Barbara Dunn for her care-

ful review of the manuscript.
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Table of Contents

IMPLIED AND LOCAL VOLATILITIES ...............................................................................1

NOTATION ......................................................................................................................2
THE ANALOGY BETWEEN LOCAL VOLATILITIES AND FORWARD RATES ..................... 2
INTRODUCING GADGETS: GADGETS FOR INTEREST RATES ............................................4
HEDGING AGAINST FORWARD RATE CHANGES ............................................................ 6
Hedging a Portfolio of Cashflows Against a Set of Forward Rates ..................8
Examples of Interest Rate Hedging Using Gadgets........................................ 10
HEDGING LOCAL VOLATILITIES: VOLATILITY GADGETS.............................................13
Relation to Forward Probability Distribution .................................................16
Constructing Finite Volatility Gadgets ...........................................................18
Using Volatility Gadgets to Hedge Against Local Volatility Changes .......... 19
AN EXPLICIT EXAMPLE ............................................................................................... 22
An Example Using Finite Volatility Gadgets ..................................................27
CONCLUSIONS...............................................................................................................28
APPENDIX A: LOCAL VOLATILITY AND THE FORWARD EQUATION FOR STANDARD
OPTIONS ......................................................................................................................29
APPENDIX B: FORWARD PROBABILITY MEASURE ...................................................33
APPENDIX C: MATHEMATICS OF GADGETS ..............................................................35

0
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

IMPLIED AND LOCAL If we think of the implied volatility of an index option as the market’s
VOLATILITIES estimate of the average future index volatility during the life of that
option, we can think of local volatility as the market’s estimate of
index volatility at a particular future time and market level. The set
of implied volatilities ΣK,T for a range of strikes K and expirations T
constitutes an implied volatility surface. We can extract from this
surface the market estimate of the local index volatility σS,t at a par-
ticular future time t and market level S. The set σS,t for a range of
index levels S and future times t constitutes the local volatility sur-
face1.

Figure 1 shows both the implied and local volatility surfaces for the
S&P 500 index on May 17, 1996. The local volatilities generally vary
more rapidly with market level than implied volatilities vary with
strike. This behavior is observed whenever global quantities are
described in term of local ones; in the interest rate world the forward
rate curve often displays more variation than the curve of spot yields
which represent the average of forward rates.

We can extract local volatilities from the spectrum of available index

options prices by means of implied models2. In these models, all
traded index options prices constrain a one-factor equilibrium pro-
cess for the future evolution of the index price so as to be consistent
with market prices while disallowing any future arbitrage opportuni-

FIGURE 1. Volatility surfaces for S&P500 index options on May 17,

1996, (a) implied volatility surface, (b) local volatility surface.

1. See Derman, Kani and Zou [1995].

2. See for example, Derman and Kani [1994], Dupire [1994] and Rubinstein [1994].

1
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

ties. In mathematical terms, the evolution over an infinitesimal time

dt in an implied model is described by the stochastic differential
equation:

dS
------ = µdt + σ ( S, t )dZ (EQ 1)
S

where S = S(t) is the index level at time t, µ is the index's expected

return and dZ = dZ(t) is the standard Wiener measure. The instanta-
neous future volatility σ(S,t) is assumed to depend only on the future
index level S and time t. This assumption allows the implied models
to remain preference-free. The requirement that the arbitrage-free
options values from this model match market prices completely fixes
the form of the local volatility function σ(S,t).

Implied models can be viewed as effective volatility models. This is

because the model averages out sources of variation in volatility
other than index level and time. If there are other sources of varia-
tion, the local volatility in implied models is effectively an average
over these variations. Therefore, the local volatility function σ(S,t) is
an expectation over all stochastic sources of uncertainty of instanta-
neous future volatility at future stock price S and time t (see Appen-
dix A for more rigorous definition), which can be computed from the
spectrum of traded option prices. Implied models are, in this sense,
options-world analogs of interest rate models with static yield curves,
in which forward rates are assumed to depend only on the future
time, and can be directly implied from the spectrum of traded bond
prices.

Much of the past decade’s history of yield curve modeling has been
concerned with allowing for arbitrage-free stochastic variations
about current forward rates. Similarly, we can in principle allow for
arbitrage-free stochastic variation about current local volatilities.

NOTATION Throughout this paper we will have the need to refer to securities
and to their values at a given time. In order to avoid confusion, we
adopt the following convention. If a security (or portfolio of securities)
is denoted by the symbol P, we use the symbol P(t) to denote its value
as time t.

THE ANALOGY BETWEEN Much of the rest of this paper relies on hacking a path through the
LOCAL VOLATILITIES AND volatility forest that parallels the route followed in the interest rate
FORWARD RATES world by users of forward rates. The forward rate from one future
time to another can be found from the prices of bonds maturing at
those times; similarly, the local volatility at a future index level and
time is related to options expiring in that neighborhood.

2
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Figure 2 illustrates the similarity between interest rates and volatili-

ties. Figure 2(a) illustrates how the infinitesimal (continuously com-
pounded) forward interest rate fT(t) between times T-∆T and T can be
computed from the prices BT(t) and BT–∆T(t) of zero-coupon bonds
maturing at times T and T–∆T respectively

BT ( t )
----------------------- = exp ( – f T ∆T ) (EQ 2)
B T – ∆T ( t )

or equivalently,

log B T – ∆T ( t ) – log B T ( t )
f T = ------------------------------------------------------------
- (EQ 3)
∆T

Figure 2(b) shows a similar but more involved relationship the local
volatility σK,T in the region near index level K and time T and options
prices CK,T(t) for options of strike K and expiration T. Assuming for
simplicity that interest rates and dividend yields are zero, this rela-
tion is

C K, T ( t ) – C K, T – ∆T ( t )
2 -----------------------------------------------------
∆T
σ K2 , T = -------------------------------------------------------------------------------------------------------------------------- (EQ 4)
C K + ∆K, T – ∆T ( t ) – 2C K, T – ∆T ( t ) + C K – ∆K, T – ∆T ( t )
--------------------------------------------------------------------------------------------------------------------------
 ∆K
2
--------
 K

FIGURE 2. Analogy between interest rate and volatility. (a) Forward

rates can be extracted from the current bond prices. (b) Local
volatilities can be extracted from the current option prices.

0 T - ∆T T 0 T - ∆T T

σK,T
(a) fT (b)

CK+∆K,T-∆T

BT CK,T-∆T CK,T
BT-∆T
CK-∆K,T-∆T

3
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

The numerator in Equation 4 is related to the value of a position in

an infinitesimal calendar spread; the denominator is related to the
value of a position in an infinitesimal butterfly spread. Therefore,
local volatility is related to the ratio of the value of calendar to but-
terfly spreads3.

Appendix A shows that the local variance σ2K,T is the conditional

risk-neutral expectation of the instantaneous future variance of index
returns, given that the index level at the future time T is K. We can
also interpret this measure as a K-level, T-maturity forward-risk-
adjusted measure. This is analogous to the known relationship
between the forward and future spot rates; fT is the forward-risk-
adjusted expectation of the instantaneous future spot rate.

INTRODUCING GADGETS: Many fixed income investors choose to analyze the risk of their port-
GADGETS FOR INTEREST folios in terms of sensitivity to forward rates. Hedging the portfolio
RATES against changes in a particular forward rate requires taking a posi-
tion in a traded instrument whose present value has an offsetting
sensitivity to the same forward rate. It is often convenient for the ini-
tial hedge to be costless, as is the case for futures contracts. An inter-
est-rate gadget is a portfolio of bonds with zero market price that has
sensitivity to only one particular forward rate. You can think of it as
something very much like a synthetic futures contract on forward
rates, constructed from a portfolio of zero-coupon bonds.

Figure 3(a) displays the construction of an infinitesimal gadget ΛT

synthesized from:

• a long position in BT , a zero-coupon bond of maturity T with value

BT(t) at time t, and
• exp(-fT (0) ∆T) units of a zero-coupon bond BT-∆T of maturity T – ∆T
of value BT-∆T(t),

where fT(0) is the forward rate between T-∆T and T at the initial time
t = 0. The value of the infinitesimal gadget ΛT at time t is given by:

Λ T ( t ) = B T ( t ) – exp [ – f T ( 0 )∆T ]B T – ∆T ( t ) (EQ 5)

3. The continuous-time equation for local volatility when rates and yields are non-
zero is given by: 2
 ∂C K, T ∂C K, T  ∂ C K, T
σ 2 K, T = 2  + ( r – δ )K + δC K, T  ⁄ K 2
∂T ∂K  ∂K2

4
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 3. Constructing gadgets from zero-coupon bonds. (a)

Infinitesimal interest rate gadget ΛT is sensitive only to the
infinitesimal forward rate fT. (b)Finite gadget ΛT1,T2 is sensitive only
to the forward rate fT1,T2.

0 T - ∆T T 0 T2 T1

fT fT1,T2

(a) (b)
BT BT1
BT-∆T

BT2

Infinitesimal gadget ΛT: Finite gadget ΛT1,T2:

(1) long one zero-coupon bond of maturity T; (1) long one zero-coupon bond of maturity T1;
(ii) short exp(-fT∆T) zero coupon bonds of (ii) short exp(-fT1,T2(T2-T1)) zero coupon
maturity T–∆T bonds of maturity T2

Combining this with Equation 2, we obtain the value of the gadget in

terms of the forward rate fT (t) at time t:

Λ T ( t ) = { exp [ – f T ( t )∆T ] – exp [ – f T ( 0 )∆T ] }B T – ∆T ( t ) (EQ 6)

The initial value (at time t = 0) of this gadget is zero, and its value is
sensitive only to the particular forward rate fT(t). As time elapses, its
value remains zero as long as the forward rate fT(t) does not change.
However, if fT(t) decreases (increases), the gadget value will corre-
spondingly increase (decrease). In this respect, the gadgets response
to changes in interest rates is similar to that of a long position in a
Eurodollar futures contract. After such a change, however, the gadget
value becomes sensitive to rates of all maturities less than T.

Figure 3(b) illustrates the construction of a finite interest-rate gadget

Λ T1, T 2 = B T1 – φ T1, T 2 B T2 (EQ 7)

consisting of a long position in a zero coupon bond BT1 and a short

position in φΤ1,Τ2 zero coupon bonds BT2 . Since the gadget is defined
to have zero initial price,

B T1 ( 0 )
φ T1, T 2 = ----------------
- = exp [ – f T 1, T 2 ( 0 ) ( T 1 – T 2 ) ] (EQ 8)
B T2 ( 0 )

5
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

φT1,T2 is the current forward discount factor4 from time T1 to time T2:
it is the discounted value at time T2 of one dollar paid at time T1,
using forward rates obtained from the current (t = 0) yield curve to do
the discounting.

The price of finite gadget ΛT1,T2 at time t is given by

Λ T 1, T 2 ( t ) = B T1 ( t ) – exp [ – f T1, T 2 ( 0 ) ( T 1 – T 2 ) ]B T2 ( t )
(EQ 9)
= { exp [ – f T1, T 2 ( t ) ( T 1 – T 2 ) ] – exp [ – f T 1, T 2 ( 0 ) ( T 1 – T 2 ) ] }B T2 ( t )

and is sensitive only to the forward rate fT1,T2 corresponding to the

interval between times T1 and T2. Note that the φ-coefficients that
define the gadgets compound, namely:

φ T1, T 3 = φ T1, T 2 φ T2, T 3 (EQ 10)

We can also view ΛT1,T2 as weighted combinations of infinitesimal

gadgets Λt, with weights φT1,t for all times t between T1 and T2.

Interest rate gadgets have well-defined sensitivities to the changes in

the respective forward rates. For a small change δfT(t) , the price
change of the infinitesimal gadget is seen from Equation 5 to be

δΛ T ( t ) = – ∆Tδ f T exp ( – f T ( t )∆T )B T – ∆T ( t )

(EQ 11)
= – ∆Tδ f T B T ( t )

Similarly for a small change δfT1,T2 , the price change of a finite gad-
get from Equation 7 is

δΛ T1, T 2 ( t ) = – ( T 1 – T 2 )δ f T 1, T 2 B T1 ( t ) (EQ 12)

HEDGING AGAINST Consider a portfolio consisting of a single zero-coupon bond BT that

FORWARD RATE CHANGES matures at time T. Instead of thinking of the gadget ΛT,T1 as the port-
folio Λ T, T 1 = B T – φ T, T 1 B T 1 , we can equivalently replicate the bond BT
by means of the bond BT1 and a gadget:

B T = Λ T, T 1 + φ T, T 1 B T1 (EQ 13)

4. The forward discount factor φT,τ satisfies the forward equation  ∂ + f T φT, τ = 0 for
∂T
all τ ≤ T and boundary condition φT,T = 1. φT,τ can be viewed as the propagator
(Green’s function) for the backward diffusion in time effected by the operator ∂ + f T .
∂T
It also satisfies the backward equation  ∂ – f t φ T, t = 0 and hence can be viewed as
∂t
the propagator for the diffusion forward in time effected by the operator ∂ – f t .
∂t

6
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

A zero coupon bond of maturity T has exactly the same payoff as the
gadget ΛT,T1 and a position in φT,T1 zero coupon bonds BT1 of shorter
maturity T1.

We can now replace BT1 by another gadget ΛT1,T2 and a position in a

bond BT2 of still shorter maturity T2, and so on, to obtain

B T = Λ T, T 1 + φ T, T1 Λ T1, T 2 + φ T, T 2 Λ T 2, T 3 + φ T, T 3 Λ T3, T 4 + ... + φ T, t B t (EQ 14)

where we have used Equation 10 to compound the φT,Tn coefficients.

The very last term Bt is a zero coupon bond with maturity at the
present time t, and is therefore equal to one dollar of cash.

φT,T' is the current forward discount factor from times T to T'. Equa-
tion 14 shows that you can statically replicate a zero coupon bond by
holding an amount of cash equal to its present value, and buying an
appropriate portfolio of costless interest-rate gadgets, each weighted
by the initial forward discount factors from bond maturity to gadget
maturity. The portfolio of costless gadgets allows you to reinvest your
cash from each gadget expiration to the next at the current forward
rate, with the quantity of gadgets available insuring the amount of
cash at each gadget expiration. In this way you can lock in the face
value of the zero coupon at final maturity5. Figure 5 illustrates this
hedging scheme for a zero-coupon bond using a simple diagram.

The gadgets provide the replication; conversely, if you own the zero
coupon bond, you can hedge it against future moves in all forward
rates, once and for all, by taking an offsetting position in the set of
gadgets.

You can replicate or hedge portfolios of future cashflows by applying

the procedure outlined above to each of them, and aggregating the
positions in the gadgets.

5. If you lack an intermediate gadget for some forward period, you can roll over your
cash at current forward rates only out to the start of that gadget period. During
the period spanned by the missing gadget, you are unhedged, and the cash may
grow at a rate different from today’s forward rate. From there on, you have gad-
gets to guarantee rolling over cash at the forward rates again, but, since the cash
grew at the wrong rate for one period, the face value the gadgets hedge may not
match the cash you actually have at that point.

7
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 5. Converting a zero-coupon bond into a portfolio of cash and

gadgets. The vertical arrows represent the cashflows of zero coupon
bonds. The lighter horizontal double arrows represent costless
interest-rate gadgets. The portfolios below are all equivalent in value
and sensitivity to forward rates.

time
0 T3 T2 T1 T

zero coupon BT with

cashflow at time T

zero coupon BT1 with

cashflow at T1 and a gadget

zero coupon BT2 with

cashflow at T2 and two gadgets

zero coupon BT3 with

cashflow at T3 and three gadgets

cash and four gadgets

Hedging a Portfolio of Consider another simple portfolio consisting of a single cash flow CT
Cashflows Against a Set of at some fixed time T in the future. Figure 6 shows how to hedge the
Forward Rates present value of this simple portfolio against a set of forward rates.
To say that we want our portfolio to be hedged against a particular
set of forward rates, we mean that we want its present value to
remain unchanged if those, and only those, forward rates undergo
some future change. We let Vτ denote the forward price at any future
time τ before T. For a cashflow CT paid at time T, the forward price Vτ
at time τ < T is defined by Vτ = φT,τCT, i.e. the discounted value of the
cashflow to time τ using the prevailing yield curve. Figure 6(a) shows
that we can hedge our portfolio against the forward rate fT1,T2 by
taking a short position in VT1 gadgets ΛT1,T2. The quantity VT1 is
observed to be independent of the forward rate fT1,T2 , so it will
remain unchanged as long as fT1,T2 is the only forward rate along the
curve that changes. Figure 4(b) illustrates hedging against two for-
ward rates fT1,T2 and fT3,T4, corresponding to two different time
intervals along the yield curve. Again, as long as all other forward
rates along the yield curve remain unchanged, we can hedge our
portfolio against both of these forward rates by taking a short posi-

8
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 6.Hedging the present value of a single cash flow against the
changes in one or more forward rates along the yield curve. (a)
hedging against a single forward rate fT1T2, (b) hedging against two
forward rates fT1,T2 and fT3,T4.

0 T2 T1 T 0 T4 T3 T2 T1 T

(a) (b) VT3 fT1,T2 VT1

fT1,T2 VT1 fT3,T4

cT cT

hedging against forward rate fT1,T2: hedging against forward rates fT1,T2 and fT3,T4:
(1) long portfolio c (1) long portfolio c
(ii) short VT1 gadgets ΛT1,T2 (ii) short VT1 gadgets ΛT1,T2
(ii) short VT3 gadgets ΛT3,T4

The same technique can be used for hedging against forward rates
corresponding to any number of specified regions along the yield
curve.

We can extend this hedging scheme to arbitrary portfolios consisting

of any number of cashflows. Figure 7 shows an example of a portfolio
with several cashflows, some of which fall within the forward rate
regions which we want to hedge our portfolio against. To do this we
will divide each region into subregions between any two consecutive
cashflows, and then hedge our portfolio against the forward rates
associated with these subregions, by taking a short position in their
respective interest rate gadgets. The correct amount to be short for
each gadget ΛTfTi, corresponding to the interval between Ti and Tf, is
VTf , the forward price at time Tf. Note that the forward price at any
time t where there is a cashflow, must include the value of the cash-
flow at that point. In Figure 7 we have shown the times where there
is a cashflow with an apostrophe symbol.

9
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 7.Hedging the present value of an arbitrary portfolio of cash

flows against forward rates within several regions along the yield
curve. We must divide each region into smaller regions between
cashflows and hedge against all of the corresponding forward rates.
0 T4 T'3 T3 T2 T''1 T'1 T1 T

VT'3 VT3 VT''1 VT'1 VT1

fT'3T4 fT3T'3 fT''1T2 fT'1T''1 fT1T'1

EXAMPLE OF INTEREST RATE Suppose we want to hedge a portfolio of zero coupon bonds against
HEDGING USING GADGETS changes in forward rates. Table 1 shows how a five-year zero coupon
bond with face value of $100 (the target) can be perfectly hedged
against changes in the forward rate between year 2 and year 3 by tak-
ing a short position in the gadget Λ3,2 , as defined in Equation 7. The
example illustrates the changes in the value of both target zero and
hedge for a two point change in the forward rate.

Table 2 illustrates how we can hedge the same target zero with two
gadgets, Λ2,1 and Λ4,3 , against a change in the forward rate between
year 1 and year 2, and a change in the forward rate between year 3
and year 4. To be specific, we allow a simultaneous change of five per-
centage points in the former, and three percentage points in the latter.

Finally, Table 3 contains a similar hedge for a target portfolio of two

zero coupon bonds, maturing respectively in year 2 and year 5 with
face values of $100. The gadgets in the hedge are used to protect the
value of the portfolio against changes in the same forward rates as in
Table 2.

10
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

TABLE 1. Using
gadgets to hedge a target five-year zero coupon bond
against changes in the forward rate between two and three years.

Initial Gadgets Gadgets Zeros Final Change in Change in

Maturity Zero Forward Zero Target in in Forward Zero Value of Value of
(years) Yields Ratesa Prices Zero Hedge Hedge Rates Prices Target Zeros Gadgets’ Zeros

1 5.00% 5.00% $95.123 Λ10 5.00% $95.123

2 5.25 5.50 90.032 Λ21 0.7925 5.50 90.032

3 5.75 6.75 84.156 Λ32 -0.8479 -0.8479 8.75 82.489 1.413

4 6.50 8.75 77.105 Λ43 8.75 75.578

5 6.75 7.75 71.355 1 Λ54 7.75 69.942 -1.413

total -1.413 1.413

a The forward rate corresponds to the one-year period ending at the corresponding maturity.

TABLE 2. Using gadgets to hedge a target five-year zero coupon bond

against changes in two forward rates. All rates are continuously
compounded and annual.

Initial Gadgets Gadgets Zeros Final Change in Change in

Maturity Zero Forward Zero Target in in Forward Zero Value of Value of
(years) Yields Ratesa Prices Zero Hedge Hedge Rates Prices Target Zeros Gadgets’ Zeros

1 5.00% 5.00% $95.123 Λ10 0.7501 5.00% $95.123

2 5.25 5.50 90.032 Λ21 -0.7925 -0.7925 8.50 87.372 2.109

3 5.75 6.75 84.156 Λ32 0.8479 6.75 81.669 -2.109

4 6.50 8.75 77.105 Λ43 -0.9254 -0.9254 13.75 71.177 5.486

5 6.75 7.75 71.355 1 Λ54 7.75 65.869 -5.486

total -5.486 5.486

a The forward rate corresponds to the one-year period ending at the corresponding maturity.

11
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

TABLE 3. Using gadgets to hedge a target portfolio of two and five-year

zero coupon bonds against changes in two forward rates. All rates are
continuously compounded and annual.

Initial Gadgets Gadgets Zeros Final Change in Change in

Maturity Zero Forward Zero Target in in Forward Zero Value of Value of
(years) Yields Ratesa Prices Zero Hedge Hedge Rates Prices Target Zeros Gadgets’ Zeros

1 5.00% 5.00% $95.123 Λ10 1.6966 5.00% $95.123

2 5.25 5.50 90.032 1 Λ21 -1.7925 -1.7925 8.50 87.372 -2.660 4.768

3 5.75 6.75 84.156 Λ32 0.8479 6.75 81.669 -2.109

4 6.50 8.75 77.105 Λ43 -0.9254 -0.9254 13,75 71.177 5.486

5 6.75 7.75 71.355 1 Λ54 7.75 65.869 -5.486

total -8.146 8.146

a The forward rate corresponds to the one-year period ending at the corresponding maturity.

12
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

HEDGING LOCAL VOLATILITIES: In the same way as the fixed-income investors analyze the interest
VOLATILITY GADGETS rate risk of their portfolios using forward rates, index options inves-
tors should analyze the volatility risk of their portfolios using local
volatilities. We have seen that it is possible to hedge fixed-income
portfolios against local rate changes along the yield curve, by means
of interest rate gadgets. Similarly, we can hedge index option portfo-
lios against local changes on the volatility surface, using volatility
gadgets. A volatility gadget is synthesized from European standard
options, just as an interest rate gadget is synthesized from zero-cou-
pon bonds. We can best illustrate its construction in a discrete world,
as shown in Figure 8. This world is described by an implied trinomial
tree6 where the stock price at any tree node can move to one of three
possible future values during a time step. The location of the nodes in
this kind of tree is generally at our disposal and can be chosen rather
arbitrarily. But, then the transition probabilities are completely con-
strained by the requirement that all the traded futures (or forwards)
and options have prices at the root of the tree which match their cur-
rent market prices. Figure 8 shows a few nodes of this tree at times
T-∆T and T. To keep our discussion general we leave the location of
the nodes arbitrary. The backward transition probabilities p, q and 1-
p-q correspond, respectively, to the diffusion forward in time from the

Synthesis of an infinitesimal volatility gadget ΩK,T using

FIGURE 8.
standard options in a discrete world.
K'
...... . . . . ..
CKu,T-∆T , Ku φu p Ku

CKm,T-∆T , Km φm 1-p-q
K, CK, T
...... ......

CKd,T-∆T , Kd φd q Kd

..... ......
K''

6. See Derman, Kani and Chriss [1996].

13
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

node Km at time T-∆T to three nodes Ku, K and Kd at time T. These

probabilities generally vary from node to node depending on the
index’s local volatility and growth rate there. They can be calculated
directly from the known market prices of standard European options
on the tree (see Footnote 6). Our analysis begins at time t = 0, hence
in what follows the probability p represents p(0) etc.

An infinitesimal volatility gadget ΩK,T in this world consists of a long

position in the call option CK,T , with strike K and expiring at T, and a
short position in φu units of the call option C K u, T – ∆T , φm units of the
call option C K m, T – ∆T and φd units of the call option C K d, T – ∆T , all expir-
ing at the previous time period T-∆T. Letting CK,T(t,S) denote the
price at time t and index level S of a call option with strike K and
expiration T, the price of the infinitesimal volatility gadget ΩK,T is
given by:

ΩK,T(t,S) = CK,T(t,S) - φuCKu, T-∆T (t,S) (EQ 15)

- φmCKm, T-∆T (t,S)- φdCKd, T-∆T (t,S)

We choose the weights φu, φm and φd of the component options so that

the total gadget value is zero at every node at time T-∆T. This condi-
tion is automatically satisfied for the node Kd or any other node
strictly below Km , like K'' in Figure 8, because with the index at
these nodes the gadget’s component options all expire out-of-the-
money and the target option has no chance of ever becoming in-the-
money. However, the target option and some or all of the component
options will have non-zero values when the index is at the node Km or
at any node above it. Table 3 shows these values at nodes Km and Ku,
and at an arbitrary node K' above Ku at time T-∆T.

TABLE 4. Thevalues of the target option and the gadget’s component

options at nodes Km, Ku and K'.

Index Level Target Option Gadget’s Component Options

at Time
T - ∆T CK,T CKd,T-∆T CKm,T-∆T CKu,T-∆T

Km e-rT p (Ku - K) φd (Km - Kd) 0 0

Ku Ku e-δT - Ke-rT φd (Ku - Kd) φm (Ku - Km) 0

K' K'e-δT - Ke-rT φd (K' - Kd) φm (K' - Km) φu (K' - Ku)

14
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

The value of the target option CK,T at time T-∆T when the index is at
the node Km is equal to the discounted expected value of its payoff
when it expires, at the next time period at time T. Since the index has
probability p of moving up from the node Km to the node Ku, where
the target option expires and pays the amount Ku - K, the value of the
target option at the node Km is given by e-rTp(Ku - K), as shown in
Table 4. In contrast, if at time T-∆T the index ends up at the node Ku
then there is no chance for the target option to expire out of the
money. At this point the value of the target option will be the same as
the value of a forward contract with delivery price K, and is equal to
Kue-δT - Ke-rT. There is a similar situation when the index is at the
node K' where the target option will be worth K'e-δT - Ke-rT. All three
options comprising the gadget expire at time T-∆T. If at this time the
index is at any node strictly below Km, all three options will expire
worthless. If the index ends up at Km, only the component option
CKd,T-∆T will be in the money. Since the weight of this option within
the gadget is φd, the total value of this component at this node is
φd(Km - Kd). Similarly, if the index ends up at Ku, only the two options
CKd,T-∆T and CKm,T-∆T will have non-zero values, respectively equal to
φd(Ku - Kd) and φm(Ku - Km). Lastly, with the index at K' at time T-∆T,
all three component options expire in the money with their values
shown in the last row of Table 4.

Requiring that the gadget value must vanish at the nodes Km, Ku
and K', we obtain three equations constraining the weights:

φd (Km - Kd) = e-r∆T p (Ku - K) (EQ 16)

φm (Ku - Km) + φd (Ku - Kd) = Ku e-δ∆T - K e-r∆T

φu (K' - Ku) + φm (K' - Km) + φd (K' - Kd) = K' e-δ∆T - K e-r∆T

The second and third equations are observed to be equivalent to a

normalization condition

φu + φm + φd = e-δ∆t (EQ 17)

and a mean condition

φuKu + φm Km + φd Kd = Ke-r∆T (EQ 18)

The first equation, the necessary condition for vanishing of the gad-
get price when S = Km, can be used to solve for the unknown weight
φd in terms of the backward diffusion probability p:

φd = e-r∆T p (Ku - K)/(Km - Kd) (EQ 19)

15
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Using puts instead of calls we can get a similar expression for φu:

φu = e-r∆T q (K - Kd)/(Ku - Km) (EQ 20)

Since, with this choice of weights, the gadget value is zero for all the
nodes at time T-∆T, it will also be zero for all of the nodes at all ear-
lier times, including the first node which corresponds to the present.

Relation to Forward Probability We can normalize the weights by the dividend factor on the right-
Distribution hand side of Equation 17, e.g φu = eδ∆t φu etc. In terms of the normal-
ized weights, Equations 17 and 18 read:

φu + φm + φd = 1 (EQ 21)

φuKu + φm Km + φd Kd = Ke-(r−δ)∆T (EQ 22)

Similarly from Equations 19 and 20 we have:

φd = e-(r−δ)∆T p (Ku - K)/(Km - Kd) , φu = e-(r−δ)∆Tq (K - Kd)/(Ku - Km) (EQ 23)

Equation 21 has the interpretation that φ ’s define a probability mea-

sure, often called the forward probability measure. This measure
relates options with different strike and expirations. It relates longer
maturity options of a given strike to options of shorter maturity and
different strikes. It can be argued that this is the probability measure
associated with a diffusion backward in time. Equation 22 shows that
the backward diffusion has a drift rate of the same magnitude, but
with opposite sign, to that of forward diffusion. Finally, Equation 23
shows that the forward and backward diffusion probabilities for dif-
fusions through small time periods are closely related. For example,
if the node spacing is constant throughout the (implied) trinomial
tree and node prices are chosen to grow along the forward curve, the
two are observed from Equation 23 to be identical. This is true only
for infinitesimal time periods and does not generally hold for finite
time periods. Appendix B discusses the relationships between for-
ward and backward measures in more mathematical detail.

At t = 0 the infinitesimal volatility gadget ΩK,T has zero price, hence

from Equation 15 for all future levels S and times t earlier than T:

CK,T(t,S) = φuCKu, T-∆T (t,S) + φmCKm, T-∆T (t,S) +φdCKd, T-∆T (t,S) (EQ 24)

This represents a decomposition of an option expiring at T in terms of

options expiring at the earlier time T-∆T. Since the coefficients φu, φm

16
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

and φd only explicitly depend on the local volatility (and not on S or t),
the same decomposition is also valid as long as local volatility does
not change.

Convolution of backward diffusions for many small time steps leads

to backward diffusion for longer time periods. This is illustrated in
Figure 9 which shows the relationship between an option CK,T , of
strike K and expiration T, to options with various strikes K' expiring
at an earlier time T'. Let Φ ( K, T, K', T' ) denote the weight of the option
CK',T' in this decomposition of the option CK,T. In our implied tree
world, this weight does not depend on the current time or the current
index level, but it does depend on local volatilities along various
paths which connect the two points (K,T) and (K',T'). Just as before,
we can modify the weights by the dividend factor eδ(T-T'), i.e. by defin-
ing Φ ( K, T, K', T' ) = e δ ( T – T' ) Φ ( K, T, K', T' ) . This modified weight can be
interpreted as the transition probability for backward diffusion from
the level K at time T to the level K' at earlier time T'.

A generalization of Equations 21-23 for finite time intervals can also

be given in terms of the modified weights as follows:

∑ Φ ( K, T, K' , T' ) = 1
i
i (EQ 25)

∑ Φ ( K, T, K' , T' )K'

i
i i = Ke –( r – δ ) ( T – T' ) (EQ 26)

FIGURE 9.Convolution of backward diffusions through small time

steps leads to backward diffusion through longer time periods.
. .. . . . .
......

CK1',T'
CK2',T'
.........

CK,T

CKn',T'

....... ......

17
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Figure 9 also illustrates a finite-time generalization of Equation 24.

At t = 0 the call option CK,T has the same value, for all future levels
S and times t at (or before) earlier time T', as a portfolio consisting of
Φ ( K, T, K', T' ) options CK',T' for all possible values of strike K', i.e.,

C K, T ( t, S ) = ∑ Φ ( K, T, K' , T' )C
i
i K i', T' ( t, S) (EQ 27)

The same decomposition also holds true as long as the local volatili-
ties for all the nodes shown in this figure do not change.

Constructing Finite Volatility By combining several infinitesimal volatility gadgets we can form
Gadgets finite volatility gadgets of various shapes and sensitivities to differ-
ent regions on the local volatility surface. Figure 10 illustrates a few
examples of finite volatility gadgets constructed in this way.

Since all infinitesimal gadgets are initially costless then every finite
volatility gadget will also be initially costless. A finite gadget will
remain costless as long all local volatilities in the nodal region
defined by that gadget remain unchanged. Its price will change, how-
ever, as soon as any of the local volatilities in this region changes.

FIGURE 10. Combining infinitesimal volatility gadgets to form various

finite volatility gadgets. Darker nodes represent long option positions
and lighter nodes represent the short option positions within the
gadget. Hollow nodes represent options for which the long and short
options precisely cancel, therefore, there is a zero net position for
these options in the gadget.
(a) (b)

(c) (d)

18
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 11.Local volatility region corresponding to a finite volatility

gadget of an arbitrary shape.

Figure 11 depicts the local volatility region corresponding to a finite

volatility gadget with an arbitrary shape. The darker boundary
points represent long options and the lighter boundary points repre-
sent the short option positions. The price of the volatility gadget is
only sensitive to the variations of local volatilities within the dotted
nodal region, and is insensitive to changes in the local volatilities in
any other region of the tree.

Using Volatility Gadgets to Suppose we wanted to hedge a standard call option CK,T , with strike
Hedge Against Local Volatility price K and expiration T, against the future changes of some local vol-
Changes atility σ(K*,T*), corresponding to the future level K* and time T*.
Figure 12(a) shows how to do this within the context of implied trino-
mial trees which we have been discussing. Analogous with the inter-
est rate case, we must short the amount Φ(K,T,K*,T*) of the
infinitesimal volatility gadget ΩK*,T* against the long position in
CK,T. This procedure will effectively remove the sensitivity of the
standard option to the local volatility σ(K*,T*). In addition, we do
this at no cost since the gadget ΩK*,T* is initially costless. Figure
12(b) shows that we can do the same for any portfolio of standard
options. The only difference in this case is that we must short an
amount equal to the sum of the weights of the infinitesimal gadgets
Σi Φ(Ki,Ti,K*,T*) over all the options whose expiration Ti is after T*.

19
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 12. Hedging portfolios of standard options against a local

volatility σ(K*,T*). (a) Hedging a single standard option CK,T . (b)
Hedging a portfolio of standard options with different strikes and
expirations.

0 T*-∆T* T* T

ΩK*,T*
(a)

CK,T

Φ(K,T,K*,T*)

ΩK*,T*
(b)

CK2,T2

CK,T
CKi,Ti

CK1,T1

Σi Φ(Ki,Ti,K*,T*)

By pasting appropriate number of infinitesimal volatility gadgets

together we can create volatility hedges against one or more finite
regions on the volatility surface. Figure 13 illustrates several exam-
ples of this construction. Figure 13(a)-(b) show this for a single stan-
dard option and Figure 13(c) shows this for arbitrary portfolios of
standard options. Finally, Figure 13(d) shows that the same can be
done when some of the options in the portfolio fall within the local
volatility regions of interest. This is analogous to the similar case in
interest rates where some of the cashflows fall within the forward
rate regions of interest, as was shown in Figure 7.

20
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 13.Examples of hedging portfolios of standard options

against one or more regions on the local volatility surface.

(a)

CK,T

(b)

CK,T

(c)
CK1,T1

CK3,T3 CK,T
CKi,Ti
CK4,T4

CK2,T2

(d)
CK1,T1

CK3,T3 CK,T

CK4,T4

CK2,T2

21
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

AN EXPLICIT EXAMPLE In this section we present a simple example of local volatility hedging
using a discrete world represented by a one-year, four-period
(implied) trinomial tree. The state space, representing the location of
all the nodes in this tree, is shown in Figure 14 below. We have
assumed that the current index level is 100, the dividend yield is 5%
per annum and the annually compounded riskless interest rate is
10% for all maturities. We have also assumed that implied volatility
of an at-the-money European call is 25%, for all expirations, and that
implied volatility increases (decreases) 0.5 percentage points with
every 10 point drop (rise) in the strike price. The state space of our
implied trinomial is chosen, for simplicity, to coincide with nodes of a
one-year, four-period, 25% constant volatility CRR-type, trinomial
tree. Figure 15 shows backward transition probabilities, Arrow-
Debreu prices and local volatilities at different nodes of this tree7.

FIGURE 14. State space of a one-year, four-period implied trinomial

tree constructed using a constant volatility of 25%.

0 0.25 0.5 0.75 1

time
(years)
202.81

169.95 169.95

142.41 142.41 142.41

119.34 119.34
B 119.34 119.34

100.00 100.00 100.00

A 100.00 100.00

83.80 83.80 83.80 83.80

70.22 70.22 70.22

58.84 58.84

49.31

7. This state space is constructed by viewing two steps of a CRR binomial tree, with
step size ∆t/2, as one step of a trinomial tree with step size ∆t. Therefore, the three
states Su, Sm and Sd are given by S u = Se σ 2∆t , S m = S and S d = Se –σ 2∆t . See Der-
man, Kani and Chriss [1996] for detailed algorithms used for computing these quan-
tities.

22
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Using Equations 17-23, we can calculate the forward transition prob-

abilities for all the nodes in the tree. The result has been shown in
Figure 16.

Suppose we wanted to hedge a standard option with strike K = 100

and expiring in T = 1 years against the changes of the local volatility
at the node A, corresponding to level K* = 100 and time T* = 0.5

FIGURE 15. Backward transition probability trees, Arrow-Debreu price

tree and local volatility tree for the example.

0 0.25 0.5 0.75 1

time
(years)

backward up-transition probability tree: 0.160

nodes show pi 0.214 0.209
0.241 0.236 0.233
0.259 0.259 0.255 0.255
0.304 0.296 0.287
0.392 0.358
0.425

backward down-transition probability tree:

0.123
nodes show qi
0.188 0.181
0.220 0.213 0.209
0.241 0.241 0.236 0.236
0.294 0.285 0.274
0.400 0.359
0.438

0.002
Arrow-Debreu price tree: 0.012 0.028
nodes show λi 0.060 0.094 0.112
0.253 0.257 0.239 0.220
1.000 0.488 0.362 0.294 0.249
0.235 0.207 0.194 0.176
0.068 0.071 0.083
0.026 0.029
0.011

local volatility tree: 0.188

nodes show σ(si ,tn) 0.224 0.221
0.240 0.236 0.235
0.249 0.249 0.247 0.247
0.272 0.269 0.264
0.313 0.298
0.327

23
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 16. Forward up- , middle- and down- transition probability

trees for the example.
0 0.25 0.5 0.75 1
time
(years)

0.000
forward up-transition probability tree: 0.000 0.000
nodes show φui 0.000 0.000 0.150
0.000 0.000 0.176 0.174
0.000 0.000 0.200 0.195 0.195
1.000 0.244 0.236 0.227
1.000 0.331 0.298
1.000 0.363
1.000

forward middle-transition probability tree: 0.000

nodes show φmi 0.000 0.811
0.000 0.747 0.604
0.000 0.715 0.545 0.552
1.00 1.000 0.494 0.504 0.504
0.000 0.756 0.414 0.434
0.000 0.669 0.280
0.000 0.637
0.000

forward down-transition probability tree: 1.000

1.000 0.189
nodes show φdi
1.000 0.253 0.246
1.000 0.285 0.278 0.275
0.000 0.000 0.306 0.301 0.301
0.000 0.000 0.350 0.339
0.000 0.000 0.423
0.000 0.000
0.000

years, in Figure 14. To construct the hedge we need the weights for
different options comprising the one-period gadget corresponding to
the local volatility at this node. The trees of weights φu, φm and φd are
shown in Figure 17. The last figure also shows the total weights
Φ(K,T,K',T').. We can use this information to compute the composi-
tion of the gadget and the number of gadgets required to be hedged.
The root of the gadget consists of a long position in Φ(100,1,100,0.75)
= 0.498 call options with strike 100 and maturing in 9 months. The
three leaves of the gadget consist of short positions in, respectively,
Φ(100,1,100,0.75)φu,100,0.75 = 0.096 calls with strike of 119.34,
Φ(100,1,100,0.75)φm,100,0.75 = 0.248 calls with strike of 100, and
Φ(100,1,100,0.75)φd,100,0.75 = 0.148 calls with strike 83.80, all expir-

24
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

FIGURE 17. Forward up- , middle- and down- weight trees for the
example.

0 0.25 0.5 0.75 1

time
(years)

0.000
up- option weight tree: 0.000 0.000
nodes show φui 0.000 0.000 0.148
0.000 0.000 0.174 0.171
0.000 0.000 0.197 0.193 0.193
0.987 0.241 0.233 0.225
0.987 0.327 0.294
0.987 0.359
0.987

middle- option weight tree: 0.000

nodes show φmi 0.000 0.801
0.000 0.737 0.596
0.000 0.706 0.538 0.545
0.987 0.987 0.488 0.498 0.498
0.000 0.747 0.409 0.428
0.000 0.660 0.276
0.000 0.629
0.000

down- option weight tree: 1.000

0.987 0.186
nodes show φdi
0.987 0.250 0.243
0.987 0.281 0.275 0.271
0.000 0.000 0.302 0.297 0.297
0.000 0.000 0.345 0.335
0.000 0.000 0.417
0.000 0.000
0.000

total gadget weight tree: 0.000

0.000 0.000
nodes show Φ(Κ,Τ,Κi,Τi)
0.034 0.000 0.000
0.247 0.200 0.193 0.000
0.950 0.301 0.370 0.498 1.000
0.414 0.269 0.297 0.000
0.102 0.000 0.000
0.000 0.000
0.000

25
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

ing in 6 months. Therefore, we can write the composition of the vola-

tility gadget as:

ΩA = 0.498*C100,0.75 - 0.148*C83.80,0.5 - 0.248C100,0.5 - 0.096*C119.34,0.5 (EQ 28)

Figure 18 illustrates the composition of the volatility gadget and its

performance against a 2% (instantaneous) change in the local volatil-

Price trees for the volatility gadget ΩA and the option CK,T
FIGURE 18.
before and after a 2% change in the local volatility σA.

0 0.25 0.5 0.75 1

time
(years)
0.000
0.000 0.000
gadget composition: 0.000 0.000 0.000
0.000 -0.096 0.000 0.000
0.000 0.000 -0.248 0.498 0.000
0.000 -0.148 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000
0.000
gadget price tree: 34.806 0.000
before 0.000 21.104 0.000
0.000 0.000 9.622 0.000
0.000 0.000 0.000 0.000 0.000
0.000 0.000 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000
option price tree: 102.811
before 70.139 69.649
43.460 42.952 42.412
23.275 21.744 20.171 19.336
11.146 9.447 7.410 4.809 0.000
2.744 1.391 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

gadget price tree: 0.000

after 34.806 0.000
0.000 21.104 0.000
0.081 0.000 9.622 0.000
0.136 0.183 0.376 0.000 0.000
0.112 0.000 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

option price tree: 102.911

after 70.139 69.649
43.460 42.952 42.412
23.355 21.744 20.171 19.336
11.282 9.630 7.786 4.809 0.000
2.856 1.391 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

26
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

ity σA.. It shows that the change in today’s price (i.e. at node (1,1)) of
the volatility gadget, when local volatility σA is changed by some
amount, precisely offsets a similar change in the option price. The
same holds at any node on the tree before time T*.

An Example Using Finite To illustrate the use of finite volatility gadgets, let us try to hedge the
Volatility Gadgets same option against changes in local volatility at both nodes A and B
of Figure 14. In Figure 19, we have shown the composition and the

FIGURE 19.Price trees for the volatility gadget ΩΑ,Β and the option
CK,T before and after a 3% change in the local volatility σA and a 5%
change in the local volatility σB.
0 0.25 0.5 0.75 1
time
(years) 0.000
0.000 0.000
gadget composition: -0.034 0.000 0.000
0.000 -0.200 0.193 0.000
0.000 0.000 -0.301 0.498 0.000
0.000 -0.148 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000
0.000
gadget price tree: 44.567 0.000
before 0.000 25.554 0.000
0.000 0.000 9.622 0.000
0.000 0.000 0.000 0.000 0.000
0.000 0.000 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

option price tree: 102.811

before 70.139 69.649
43.460 42.952 42.412
23.275 21.744 20.171 19.336
11.146 9.447 7.410 4.809 0.000
2.744 1.391 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

gadget price tree: 0.000

after 44.567 0.000
0.000 25.554 0.000
0.348 0.430 9.622 0.000
0.315 0.385 0.566 0.000 0.000
0.168 0.000 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

option price tree: 102.911

after 70.139 69.649
43.460 42.952 42.412
23.622 22.174 20.171 19.336
11.462 9.832 7.976 4.809 0.000
2.912 1.391 0.000 0.000
0.000 0.000 0.000
0.000 0.000
0.000

27
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

performance of the of the finite gadget in this case. The gadget compo-
sition is given by
ΩΑ,Β = 0.498*C100,0.75 + 0.193*C119.34,0.75 - (EQ 29)

0.148*C83.80,0.5 - 0.301C100,0.5 - 0.200*C119.34,0.5 - 0.034*C142.41,0.5

The figure also shows that this gadget performs well against a 3%
instantaneous change in the local volatility σA and a simultaneous 5%
instantaneous change in the local volatility σB.

CONCLUSIONS We can use traded instruments to hedge fixed income portfolios against
the future uncertainty in the forward rates. We can synthesize simple
bond portfolios, with zero initial price, whose values are (initially) sen-
sitive only to specific forward rates. We call these portfolios interest
rate gadgets. By taking a positions in different of interest rate gadgets,
corresponding to different future times, we can hedge our fixed income
portfolio against the future changes of the forward rates in any region
along the yield curve. Because gadgets have zero market price, this
procedure is theoretically costless.

We can devise a similar method for hedging index options portfolios

against future local volatility changes. We can synthesize zero-cost vol-
atility gadgets from the standard index options. By buying or selling
suitable amounts of volatility gadgets, corresponding to different
future times and market levels, we can hedge any portfolio of index
options against the local volatility changes on any of regions on the vol-
atility surface. Again, this procedure is theoretically costless. It can be
used to remove an unwanted volatility risk, or to acquire a desired vol-
atility risk over any range of future index prices and time.

28
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

APPENDIX A: Local Volatility This appendix provides the general definition for local volatility. It
and the Forward Equation for also derives the forward equation for standard options which allows
Standard Options extraction of the local volatility function from the standard options
prices.

We assume8 a risk-neutral index price evolution governed by the sto-

chastic differential equation

dSt/St = rt dt + σt dZt (EQ 30)

where rt is the riskless rate of return at time t, assumed to be a deter-

ministic function of time, and σt is the instantaneous index volatility
at time t, assumed to follow some as yet unspecified stochastic pro-
cess9. Zt is a standard Brownian motion under the risk-neutral mea-
sure. Let E(.) = Et(.) denote the expectation, based on information at
time t, with respect to this measure. This information may include,
for example, the index price St (or Zt) and the values of n additional
independent stochastic factors Wit , i = 1,...n, which govern the sto-
chastic evolution of index volatility σt.

The payoff of the standard European call option, with strike K and
expiration T, is given by (ST - K)+. Formal application of Ito’s lemma
with this expression gives

d(ST - K)+ = θ(ST - K) dST + 1/2 σ2TS2T δ(ST - K) dT (EQ 31)

where θ(.) is the Heaviside function and δ(.) is the Dirac delta func-
tion. Taking Expectations of both sides of this relation and using
Equation 30 leads to

d E {(ST - K)+ } = rT E { ST θ(ST - K) } dT + 1/2 E { σ2T S2T δ(ST - K) } dT (EQ 32)

We can rewrite the first term in more familiar form noting that

E { ST θ(ST - K) } = E { (ST - K)+ } + K E { θ(ST - K) } (EQ 33)

The standard European call option price is given by the relation10

CK,T = DT E{(ST - K)+} where DT denotes the discount function corre-

8. We will not present any arguments for the existence or uniqueness of the risk-
neutral measure here and, instead, merely postulate it in order to present the expec-
tation definition of local volatility. Equation 39 gives an alternative definition of local
volatility which does not a priori require the existence of this measure.
9. Subject to the usual measurability and integrability conditions.
10. The dependence on t, St and the n stochastic factors Wit (or possibly their past
values) at time t is implicit in this and other expectations computed at time t.

29
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

∫
T
sponding to maturity T, i.e. D T = exp [ – t
r ( u ) du ] . Differentiating once
with respect to K gives

dCK,T/dK = DT E {θ(ST - K)} (EQ 34)

Differentiating twice with respect to K gives

d2CK,T/dK2 = DT E { δ(ST - K) } (EQ 35)

while differentiating with respect to T leads to

dCK,T/dT = rT DT E { (ST - K)+ } + DT dE{ (ST - K)+ }/dT (EQ 36)

Replacing the last term from Equation 32 combined with Equations

33-36 we find

dCK,T/dT = rT K dCK,T/dK + 1/2 K2 E{ σ2T δ(ST - K)} (EQ 37)

We define local variance σ2K,T , corresponding to level K and maturity

T, as the conditional expectation of the instantaneous variance of
index return at the future time T, contingent on index level ST being
equal to K:

σ2 K,T = E { σ2T | ST = K } = E { σ2T δ(ST - K) } / E { δ(ST - K) } (EQ 38)

Local volatility σ K,T is then defined as the square root of the local
variance, σ K,T = (σ2 K,T )1/2. Using Equation 35, we can rewrite Equa-
tion 37 in terms of the local volatility function:

dCK,T/dT = rT K dCK,T/dK + 1/2 K2 σ2K,T d2CK,T/dK2 (EQ 39)

This is the forward equation satisfied by the standard European

options. It is consistent with Dupire’s equation11 when instantaneous
index volatility is assumed to be a function of the index level and
time, i.e. when σT = σ(ST ,T). In this case

σ2 K,T = E { σ2T | ST = K } = E { σ2(ST ,T) | ST = K } = σ2(K, T) (EQ 40)

Equation 39 can be used as an alternative definition of local volatil-

ity. This definition has the added advantage that it does not require
the knowledge of a risk-neutral measure and it is entirely defined in
terms of traded option prices. Viewed as a function of future level K
and maturity T, σK,T defines the local volatility surface. In general,
there is an implicit dependence of this surface on time t, index price
St, and variables Wit , i = 1, ..n, or possibly their past histories. In the

11. See, for instance, Dupire [1994] or Derman and Kani [1994].

30
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

specific case when σT = σ(ST ,T), though, these dependencies collec-

tively disappear, and we are left with a static local volatility surface
whose shape remains unchanged as time evolves. We can also think
of these as effective theories where expectations of future volatility
have been taken (at some point in time) and the resulting local vola-
tility surface is assumed to remain fixed for the subsequent evolu-
tion. In an effective theory, the instantaneous index volatility is then
effectively only a function of the future index level and future time,
and no other source of uncertainty.

In the more general stochastic setting, we can describe the evolution

of σ2 K,T by the stochastic differential equation

dσ2 K,T /σ2 K,T = αK,T dt + βK,T dZt + θiK,T dWti (EQ 41)

The drift αK,T and volatility functions βK,T and θiK,T are in general
functions of time t, index level St and factor values Wit and their past
histories. There is also an implied summation over the index i this
equation. in As we can see from Equation 40, the special case of a
theory with σT = σ(ST ,T) corresponds to dσ2 K,T = 0, leading to zero
values for all these functions.

The expression in the denominator of Equation 38 describes the prob-

ability that the index level at time T arrives at ST = K. Denote this
probability12 by PK,T

PK,T = E { δ(ST - K) } (EQ 42)

Now consider the stochastic differential equation describing the evo-

lution of this probability

dPK,T / PK,T = φK,T dZ + χiK,T dWi (EQ 43)

The vanishing drift in this equation results from the fact that PK,T is
a local martingale. Because the numerator on the right-hand-side of
Equation 38 is also a martingale, a simple application of Ito’s lemma
to both sides of that equation under the assumption that the Brown-
ian motions Wi and Z are uncorrelated gives

αK,T + βK,T φK,T + θiK,T χiK,T = 0 (EQ 44)

Using this identity we can rewrite Equation 41 in another form

12. Normally we would write this probability as P(t,St,K,T) with the dependence on
Wit (and possibly the history) implicitly understood.

31
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

dσ2 K,T /σ2 K,T = βK,T (dZ - φK,T dt) + θiK,T (dWi - χi K,T dt) (EQ 45)

i
We see that in terms of the new measures dẐ = dZ - φK,T dt and dŴ =
dWi - χi K,T dt the local variance is a martingale:

dσ2 K,T /σ2 K,T = βK,T dẐ + θiK,T dŴ

i
(EQ 46)

We call this new measure the K-level, T-maturity forward risk-

adjusted measure in analogy with T-maturity forward risk-neutral
measure in interest rates (see Jamshidian [1993]).

Letting EK,T(.) denote expectations with respect to this measure, we

can rewrite Equation 38 in a simpler form:

σ2 K,T = EK,T { σ2T } (EQ 47)

Therefore, in the K-T forward risk-adjusted measure the local vari-

ance σ2 K,T is the expectation of future instantaneous variance σ2T .
This is analogous to a similar situation in interest rates where the
forward rate fT is the T-maturity forward risk-adjusted expectation of
the future spot (short) rate at time T.

32
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

APPENDIX B: Forward Probabil- In this appendix we define the concept of forward probability mea-
ity Measure sure when the index price evolution is governed by some general
(multi-factor) stochastic volatility process, as described in Equation
30. In Appendix A we have already seen the definition of backward
probability measure. Setting S = St and using the expanded notation
P(t,S,K,T) in place of PK,T and Dt,T in place of DT, Equation 42 gives
2 t, S
1 ∂C K, T
P(t,S,K,T) = Et,S { δ(ST - K) } = ----------- (EQ 48)
D t, T ∂ K 2

There is an implicit dependence on stochastic factors Wi and perhaps

their history at time t which we will collectively denote by ωt , thus
ω
P ( t, S, K, T ) = P t ( t, S, K, T ) . In an effective theory where σK,T = σ(K, T)
the local volatility surface is static and remains unchanged as time
elapses, therefore there is no dependence on ωt. In this theory, Euro-
pean option price C is related to probability P through the relation:

∫
t, S t', S'
C K, T = D t, T P ( t, S, t', S' )C K, T dS' (EQ 49)
0

Also in an effective theory, P satisfies the forward Kolmogorov equa-

tions:

2
∂ 1 2 ∂ ∂
--- σ ( S', t' )S' P ( t, S, t', S' ) –
2
2  ∂ S'
( ( r ( t' ) – δ ) S'P ( t, S, t', S' ) ) = P ( t, S, t', S' ) (EQ 50)
∂ S' 2 ∂ t'

It also satisfies the backward Kolmogorov equation

2
1 2 2 ∂ ∂ ∂
--- σ ( S, t )S P ( t, S, t', S' ) + ( r ( t ) – δ ) S P ( t, S, t', S' ) = – P ( t, S, t', S' ) (EQ 51)
2 2 ∂S ∂t
∂S

and, for any t' such that t ≤ t' ≤ T , the Chapman-Kolmogorov relation

∞
P ( t, S, T, K ) =
∫0
P ( t, S, t', S' )P ( t', S', T, K ) dS' (EQ 52)

Fixing ωt in a general theory has the effect of restricting the evolu-

tion of index price to be based on volatilities along the particular sur-
wt
face of local volatilities σ S , T corresponding to ωt. This evolution
T
defines an effective theory for each w, in which index price evolves
with an effective instantaneous volatility function σT = σ(ST , T) =
w
σS t , T and whose transition probability measure is P t . Once we fix
w

T
ωt, and restrict the evolution to a particular local volatility surface,

33
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

we are within the context of effective theories and all of Equations

49-52 apply.

In Appendix A, we showed that the European option price satisfies

the forward equation, given by Equation 39. For a fix ω this can be
shown to be equivalent to existence of a forward probability density
function Φ(K,T,K',T') defined by the relation

∞
∫
t, S t, S
C K, T = e –δ ( T – t ) Φ ( K, T, K', T' )C K', T' dK' (EQ 53)
0

and satisfying the forward equation (for σ(K, T) = σωK,T ):

2
1 2 ∂ ∂ ∂
--- σ ( K, T ) Φ ( K, T, K', T' ) – ( r T – δ ) K Φ ( K, T, K', T' ) = Φ ( K, T, K', T' ) (EQ 54)
2 2 ∂K ∂T
∂K

as well as the Chapman-Kolmogorov equation for any T̃ such that

T ≥ T̃ ≥ T'

∞
Φ ( K, T, K', T' ) =
∫ 0
Φ ( K, T, K̃, T̃ )Φ ( K̃, T̃, K', T' ) dK̃ (EQ 55)

We can argue that Φ defines the transition probability density for the
evolution backward in time along the effective local volatility surface
defined by ω. we can also view Φ(K,T,K',T') as the propagator (or
green’s function) for the diffusion backward 2
in time associated with
the differential operator ∂∂T – 1--2- σ 2K, T ∂ 2 + ( rT – δ ) K ∂∂K . Furthermore, it fol-
∂K
lows from Equation 53 that
2 t, S
∂
C K, T
Φ ( t, S, K, T ) = eδ(T – t) (EQ 56)
∂S2

34
 Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

APPENDIX C: Mathematics of In this appendix we present an alternative construction for gadgets

Gadgets using the diffusion equations satisfied by traded assets. First we con-
sider interest rate gadgets. The zero-coupon bond prices satisfy the
forward differential equation

 ∂ + f ( t ) B ( t ) = 0 (EQ 57)
∂T T  T

Here BT(t) is the price at time t of a T-maturity zero-coupon bond sat-

isfying the terminal condition BT(T) = 1. The explicit solution T
of
 
but we do not require this explicit form for our arguments here. t
∫
Equation 57 is the familiar bond pricing formula BT ( t ) = exp  – f u ( t ) du ,
Let
φT,T'(t) denote the green’s function associated with the operator
∂
expression + f T ( t ) . This means that φT,T(t) = 1 for all T and t ≤ T ,
∂T
and that for all times t ≤ T' ≤ T

 ∂ + f ( t ) φ ( t ) = 0 (EQ 58)
∂T T  T, T'

In terms of the Green’s function the solution of Equation 57 is given

by

B T ( t ) = φ T, T' ( t )B T' ( t ) (EQ 59)

Since Bt(t) = 1, it follows that BT(t) = φT,t(t). Equation 59 has an inter-

pretation which is useful for constructing interest rate gadgets. To
see this construct a portfolio ΩT,T' consisting of a long one T-maturity
bond, BT , and short φT,T'( t = 0 ) of T'-maturity bonds BT'

Λ T, T' = B T – φ T, T' ( 0 )B T' (EQ 60)

We call this portfolio the interest rate gadget associated with the
time interval between T' and T. From Equation 59, the gadget price
at time t = 0 is zero. Its price will change, however, if (and only if) the
forward rate fT,T' associated with interval between T' and T changes.
For T' = T - ∆T with small ∆T we obtain infinitesimal interest rate
gadgets ΛT = ΛT,T-∆T . We can construct finite interest rate gadgets
from infinitesimal ones. The finite gadget ΛT,T' , for instance, can be
mathematically described as

T
Λ T, T' =
∫ T'
φ T, u Λ u du (EQ 61)

The volatility gadgets can be constructed in a similar way. Traded

standard option prices satisfy the forward differential equation

35
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

2
 1--- σ 2 ( t )K 2 ∂ – ( r – δ )K ∂ – ∂ – δ C ( t ) = 0 (EQ 62)
 2 K, T ∂K2 T
∂ K ∂ T  K, T

where CK,T(t) is the price at time t of a K-strike, T-maturity standard

European call option with the terminal condition CK,T(T) = Max(ST -
K, 0). Contrary to the interest rate case, an explicit solution of Equa-
tion 62 is unavailable, but is not needed for our discussion here. Let
ΦK,T,K',T'(t) denote the green’s function associated with the operator
2
∂ ∂
1 2
--- σ K, T ( t )K 2
2
– ( r – δ )K –
∂K ∂T
∂
. Therefore ΦK,T,K',T(t) = δ(K' - K) for all values
∂K2
of K, K' and times t ≤ T , and furthermore, for all t ≤ T' ≤ T

2
 1--- σ 2 ( t )K 2 ∂ – ( r – δ )K ∂ – ∂  Φ (t) = 0 (EQ 63)
 2 K, T ∂K2 ∂ K ∂ T K, T, K', T'

The solution of Equation 62 in terms of this Green’s function can be

written as

∞
C K, T ( t ) =
∫ 0
Φ K, T, K', T' ( t )C K', T' ( t ) dK' (EQ 64)

before, Equation 64 finds an interpretation0

∫
Setting T' = t we see that C K, T ( t ) = Φ K, T, K', T ( t )Max ( S t – K', 0 ) . As
in terms of volatility gad-
gets. Consider a portfolio composed of a long position in one K-strike
and T-maturity (European) standard call option and a short position
in ΦK,T,K',T'( t = 0 ) units of K'-strike and T'-maturity standard call
options for all values of K' and T' with t ≤ T' ≤ T , i.e

∞
Ω K, T, T' = C K, T –
∫ 0
Φ K, T, K', T' ( 0 )C K', T' dK' (EQ 65)

Setting T' = T - ∆T we find infinitesimal volatility gadgets ΩK,T =

ΩK,T,T-∆T. The finite gadget ΩK,T,T' can be constructed out of infinites-
imal gadgets, formally as

T ∞
Ω K, T, T' =
∫ ∫
T' 0
Φ K, T, v, u ( 0 )Ω v, u dv du (EQ 66)

In fact by combining infinitesimal volatility gadgets, we can con-

struct an infinite variety of finite volatility gadgets associated with
any given region of the volatility surface. Let R be any such region
(not necessarily connected) and define a finite volatility gadget ΩR
associated with that region as

ΩR =
∫Φ
R
K, T, v, u ( 0 )Ω v, u (EQ 67)

36
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

Viewing volatility gadgets as a collection of standard options, we can

argue that the standard options which comprise ΩR all lie on the
boundary of the region R. A mathematical way of seeing this is by
noting that formally ΩK,T = AK,T CK,T where AK,T is the differential
operator in Equation 62. It can be shown that if A*K,T is the dual of
the operator AK,T then A*K,T ΦK,T,K',T' = 0 for all K' and T' ≤ T . Our
assertion then follows from Equation 67 using integration by parts.

37
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

REFERENCES

Derman, E. and I. Kani (1994). Riding on a Smile. RISK 7 no 2, 32-

39.

Derman, E., I. Kani and N. Chriss (1996). Implied Trinomial Trees of

the Volatility Smile. Journal of Derivatives, Vol. 3, No. 4, 7-22.

Derman, E., I. Kani and J. Zou (1995). The Local Volatility Surface.
To appear in Financial Analyst Journal.

Dupire, B. (1994). Pricing with a Smile. RISK 7 no 1, 18-20.

Jamshidian, F. (1993). Option and Futures Valuation with Determin-

istic Volatilities, Mathematical Finance, Vol. 3, No. 2, 149-159.

Rubinstein, M.E. (1994). Implied Binomial Trees, Journal of Finance,

69, 771-818.

38
Goldman
Sachs
QUANTITATIVE STRATEGIES RESEARCH NOTES

SELECTED QUANTITATIVE STRATEGIES PUBLICATIONS

June 1990 Understanding Guaranteed Exchange-Rate

Contracts In Foreign Stock Investments
Emanuel Derman, Piotr Karasinski
and Jeffrey S. Wecker

January 1992 Valuing and Hedging Outperformance Options

Emanuel Derman

March 1992 Pay-On-Exercise Options

Emanuel Derman and Iraj Kani

June 1993 The Ins and Outs of Barrier Options

Emanuel Derman and Iraj Kani

January 1994 The Volatility Smile and Its Implied Tree

Emanuel Derman and Iraj Kani

May 1994 Static Options Replication

Emanuel Derman, Deniz Ergener
and Iraj Kani

May 1995 Enhanced Numerical Methods for Options

with Barriers
Emanuel Derman, Iraj Kani, Deniz Ergener
and Indrajit Bardhan

December 1995 The Local Volatility Surface

Emanuel Derman, Iraj Kani and Joseph Z. Zou

February 1996 Implied Trinomial Trees of the Volatility Smile

Emanuel Derman, Iraj Kani and Neil Chriss

39